What Are ETFs?
In the simplest terms, Exchange Traded Funds (ETFs) are funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate its performance. They don't try to beat the market, they try to be the market.
ETFs have been around since the early 1980s, but they've come into their own within the past 10 years.
ETFs combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors can purchase ETF shares on margin, short sell shares, or hold for the long term.
ETFs for Passive Management
The purpose of an ETF is to match a particular market index, leading to a fund management style known as passive management. Passive management is the chief distinguishing feature of ETFs, and it brings a number of advantages for investors in index funds. Essentially, passive management means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. This is quite different from an actively managed fund, like most mutual funds, where the manager continually trades assets in an effort to outperform the market. Because they are tied to a particular index, ETFs tend to cover a discrete number of stocks, as opposed to a mutual fund whose scope of investment is subject to continual change. For these reasons, ETFs mitigate the element of "managerial risk" that can make choosing the right fund difficult. Rather than investing in a fund manager, when you buy shares of an ETF you're harnessing the power of the market itself.
Cost-efficiency and Tax-efficiency
Because an ETF tracks an index without trying to outperform it, it incurs fewer administrative costs than actively managed portfolios. Typical ETF administrative costs are lower than an actively managed fund, coming in less than .20% per annum, as opposed to the over 1% yearly cost of some mutual funds. Because they incur low management and sponsor fees, and because they don't typically carry high sales loads, there are fewer recurring costs to diminish your returns.
Passive management is also an advantage in terms of tax efficiency. ETFs are less likely than actively managed portfolios to experience the trading of securities, which can create potentially high capital gains distributions. Fewer trades into and out of the trust mean fewer taxable distributions, and a more efficient overall return on investment.
Efficiency is one reason ETFs have become a favored vehicle for multiple investment strategies - because lower administrative costs and lower capital gains taxes put a greater share of your investment dollar to work for you in the market.
Flexibility of ETFs
ETF shares trade exactly like stocks. Unlike index mutual funds, which are priced only after market closings, ETFs are priced and traded continuously throughout the trading day. They can be bought on margin, sold short, or held for the long-term, exactly like common stock. Yet because their value is based on an underlying index, ETFs enjoy the additional benefits of broader diversification than shares in single companies, as well as what many investors perceive as the greater flexibility that goes with investing in entire markets, sectors, regions, or asset types. Because they represent baskets of stocks, ETFs, or at least the ones based on major indexes, typically trade at much higher volumes than individual stocks. High trading volumes mean high liquidity, enabling investors to get into and out of investment positions with minimum risk and expense.
Long-Term Growth of ETFs
It was in the late 1970s that investors and market watchers noticed a trend involving market indexes - the major indexes were consistently outperforming actively managed portfolio funds. In essence, according to these figures, market indexes make better investments than managed funds, and a buy-and-hold strategy is the best strategy to reap the advantages of investing in index growth.
How Do Indexes Work?
A stock market index is a list of related stocks, together with statistics representing their aggregate value. It is used chiefly as a benchmark for indicating the value of its component stocks, as well as investment vehicles such as mutual funds that hold positions in those stocks. Indexes can be based on various categories of stocks. There are the widely known market indexes, such as the Dow Jones Industrial Average, the NASDAQ Composite, or the S&P 500. There are indexes based on market sectors, such as tech, healthcare, financial; foreign markets; market cap (micro-, small-, mid-, large-, and mega-cap); asset type (small growth, large growth, etc.); even commodities.