An exchange-traded fund (ETF) is a kind of investment security that tracks an index, a sector, a geography or virtually any other aggregation of assets based on defined criteria. And it can be traded on an exchange the same way a regular stock can.
Since their introduction about 30 years ago, ETFs have gone from exotic, to popular, to ubiquitous. After years of double-digit growth, they are now in virtually every investor’s portfolio, with a staggering global value of roughly USD 9 trillion. This meteoric rise in relevance is the result of a combination of winning factors: they are a simple, cost-effective way to create diversified investment portfolios.
Funds or single stock?
Investors’ increasing preference for funds over single stocks is easily explained. When you choose to buy a single stock, you are essentially trying to pick an individual winner (or loser, if you are shorting it) in the market. But stock picking is a notoriously hard game to play, one that you are far more likely to lose than win. When you buy a fund, you are buying a much larger selection of instruments, achieving a far greater degree of diversification with a single trade.
A fund is to a single stock what a shoe store is to a pair of sneakers.
Diversification means less risk, and same average expected returns but without outlier potential. But it also means smaller losses if you get on the wrong side of the market.
ETF or mutual fund?
For decades, mutual funds have provided a smart and convenient way to achieve broad diversification, together with professional management (i.e. stock selection) and liquidity. But ETFs have gone several steps further, improving on many shortfalls of the typical mutual fund. Here are some of the key advantages.
Mutual funds are priced once a day at their Net Asset Value, while we can buy and sell ETFs like shares, at the prevalent market price at the moment the trade takes place.
ETFs, which are for the most part passively managed, have much lower overhead, operational and administrative costs (i.e. accounting, distribution and marketing costs) – or management fees. Management fees should be a welcome cost for investors if actively-managed funds consistently beat their benchmark indexes, at least enough to more than cover management fees. But there is no evidence to support that they do.
In some countries, like the USA, mutual funds must distribute capital gains to shareholders when a position is closed at a profit, and this distribution is taxable, regardless of whether the overall investment in the fund has been profitable. Conversely, investors in ETFs only pay capital gain taxes when they sell their investment.
The dividends of the companies in accumulating ETFs (those that reinvests dividends rather than distributing them) are – generally – reinvested immediately. For mutual funds the reinvestment timing varies, therefore creating a ‘dividend drag’.
What about actively-managed ETFs?
Actively-managed ETFs are exactly what the name says. They essentially retain the same advantages that ETFs have over mutual funds, but they are not as cost efficient since there is a manager actively deciding which components of an index to focus on. They are still a small (but growing) percentage of the overall ETFs universe, and their appeal entirely depends on the ability of a manager to convince investors of his/her ability to beat a reference index, consistently.
There is no sign of the ETF market slowing down. Even during the most extreme bouts of volatility 2020, investors’ appetite showed unexpected resilience and only a few markets experienced net ETF outflows. The question is no longer why to invest in ETFs, but which ETFs to choose.