Although the first ETFs were created almost 20 years ago, the ETF industry has blossomed over the last decade, with assets now totaling more than $2 trillion and ETF assets climb in bull and bear markets alike. It’s a secular trend.
Indeed, the ETF industry is growing at the expense of traditional mutual funds and brokerages, many of which lost credibility during the financial crisis. Moreover, the diversity of the ETF world is particularly attractive not only to self-directed investors/traders, but to independent financial advisors, a group that has gained credibility in recent years. Here are my top 10 reasons that so many investors are now ‘playing’ ETFs.
1. Lower Expenses / Higher Returns
According to John Bogle, the legendary founder of the Vanguard family of funds, expense ratios matter greatly over time. Bogle, the father of indexing, argues that active management generally fails to add value over the long term and he would appreciate the fact that most ETFs are passively indexed. The average annual mutual fund expense ratio is about 1.4%, whereas ETFs typically charge less than half as much (15-90 basis points).
It is not difficult to build a balanced all-ETF portfolio with an annual expense ratio around 30 basis points because with ETFs, you are not paying for a team of high-priced managers and analysts. Moreover, ETFs are traded like stocks, between investors themselves, which means that the issuer incurs less administrative costs processing redemptions and managing accounts.
2. Intraday Trading
Volatility has been increasing in general in the equity markets, largely due to the surge in algorithmic trading, which now accounts for more than 60% of total volume on the NYSE.
The purchase or sale of mutual fund shares is a transaction that is processed at the end of the trading day based on a closing price.
That lag can translate into a difference of several hundred basis points in value (100 basis points = 1%) depending on the volatility of the day and the instrument. ETFs, however, are priced every few seconds, which is a great advantage for active traders and fund managers.
3. Enhanced Sub-Sector Precision
ETFs were originally designed for indexing the major sectors and indices , but these securities have become increasingly popular among aggressive traders, as well.
The ETF lineup now includes highly targeted sub-sectors and sub-industries, from Solid State Disc Drives to Junior Gold Miners to Fishing Stocks.
While unleveraged ETFs are popular among investors with long-term time horizons, the leveraged variety are widely used by active traders to capture ‘alpha’ i.e. outperformance relative to a benchmark.
Leveraged ETFs deliver amplified volatility for those who can handle it. There is a tracking error, however, in leveraged ETFs that traders need to be aware of if you plan on holding overnight.
5. Tax Efficiency
ETFs are known for being cost efficient, but their tax efficient properties can be equally compelling. Whereas mutual funds may generate tax liabilities based on the redemption decisions of others
(one may owe capital gains taxes in a down year even if you did not sell/redeem any shares), ETFs avoid incurring short-term capital gains taxes when creating or redeeming new shares. ETFs, therefore, give investors more control over their short and long-term tax liabilities.
Due to competition among mutual fund managers, fund investors are not privy to up-to-date information on fund holdings. Even the quarterly reports may not give precise details.
Whatever your investment strategy, it can be useful to know the details of fund exposure. A list of undelying holdings is available from the fund manager and is typically updated daily.
Additionally, ETFs provide exposure to companies on foreign exchanges that most investors lack access to. Knowing the company names allows ETF investors to vet the more obscure holdings, as well.
7. Commission-Free Trading
Like any equity, ETFs incur trading commissions, but that ‘penalty’ has been mitigated to some degree thanks to the expansion of commission-free ETF trading programs. If you plan to hold for 30 days or more,
there are now more than 200 ETFs available commission-free from certain brokerages, so investors and traders can manage a diverse portfolio with reduced costs. Check with your brokerage for details.
8. No Minimums
Most mutual funds come with minimum investment requirements. In some cases, they are just a few thousand dollars, but certain products require five figures just to get started.
ETFs can be purchased one share at a time.
9. No Redemption Fees (or delays)
In addition to charging higher maintenance fees, many mutual funds also charge a redemption fee if you close out a position before a certain amount of time has elapsed.
With ETFs, there is no penalty for market timing… or selling for any other reason.
10. Designed for the Self-Directed Investor/Trader
The world of exchange-traded products is a virtual department store for self-directed investors/traders. Whether one seeks to “beat the market” or hedge the market,
ETFs offer the individual more choices at your fingertips than mutual funds ever could. Anything mutual funds can do, ETFs can do better.