Back to the basics: ETF 101

avatar By: IS
Date posted: 11.24.2010 (5:36 am) | Write a Comment  (7 Comments)

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It’s a basic question but one worth looking into. I received a few emails in the past few weeks inquiring about it and while I did discuss the reasons why I prefer ETF’s over mutual funds, I have not really taken the time to explain what an ETF is, what purpose it serves and why it has gained so much traction in the past few years..

What it is

An ETF is a short name for an exchange traded fund. Say what?

Chances are that you know what a mutual fund is. Basically,  imagine a fund manager that wants to manage $100,000. He could simply sell 10,000 “units” at $10 each. Every time an investor wants to buy or sell units, he can do so at the end of a trading day.

An ETF is very similar except when you buy, you’re not buying from the fund manager in almost all cases. You are buying a unit from someone else as if you were buying a stock. How? You simply open a brokerage account, deposit some money and then can buy the ETF as if you were buying any other stock. That means you can get in and out of your position at any point during the day which is certainly an advantage.

Short and long term investing

Because of the way they are built, ETF’s have been used increasingly both for short and long term investing. Because of their very high liquidity, ETF’s have been a great way for sort term traders to gain exposure or hedge against specific events. Before the arrival of ETF’s, gaining exposure quickly of specific investments such as metals involved trading futures and often ended up costing a fair amount of costs.

In my opinion, the bigger advantage goes to long term investing though. Investors that were using mutual funds can now get the same exposure and pay between 1% and 3% of fees less than what they were paying. Over time, those fees make a huge difference and will often result in tens or even hundreds of thousands of dollars. ETF’s are not perfect but for long term investing, the upside is very significant.

Low Fees

Speaking of low fees, the difference is very significant. I met someone from Fidelity, one of the major mutual fund players who told me that the average fee on its funds was a bit over 2% per year. Compare that to ETF’s… We looked at unknown ETF facts recently and the most expensive ETF’s are about 1%. But for the more mainstream exposures such as the S&P500, the fees are generally under 0.10%. That is a major economy for the average investor over the years. Why do they charge less?

-ETF’s are much more transparent: Since comparing mutual funds is much more difficult, it’s nearly impossible for you to prove that your adviser is not truly “working for you”. In the ETF world however, you can easily compare funds and the fees that they charge which makes it easy even for average investors to get the “best deal”.

-Sold by advisers: Mutual funds are usually sold by someone who is getting a cut on your investment every year, a trailer fee. That person does not necessarily have the motivation to get you the “best investment” as it is not what will give him the best revenues.

-More efficient structure: In a mutual fund, much more trading must be done in order to meet all of the investors buy and sell transactions. That results in more trading fees and less tax efficiency. Since ETF’s have a more efficient structure, their fees are minimal which makes it possible for them to charge less.

Exposure to additional asset classes

Until recently, it was complex and costly for individual and smaller investors to get exposure to asset classes such as commodities and bonds. Yes, in theory an investor had the possibility of opening up a futures account, deposit margin and start trading futures. But in practice, it was much more difficult. In the same way, trading bonds was possible but since small investors have to trade much smaller quantities, they usually end up paying much more for bonds than a larger investor would. That made it difficult and not very attractive for investors to trade such asset classes. But thanks to ETF’s, it is now much easier for these investors to go long on gold, oil or gain exposure to corporate or government bonds.

Another aspect was getting international exposure to fixed income or foreign markets. Some of these companies did list shares on US exchanges as ADR’s but I think it’s safe to say that ETF’s have improved the scope of possibilities for small and even large investors and for that we should all be very thankful.

Targeted exposure

While there are thousands or mutual funds, many of them cover the same exposures. Every mutual fund issuer (there are hundreds) has a fund that covers the S&P500. Why? Because every adviser will generally recommend the funds issued by his firm or his affiliated firm. In the ETF world, you will rarely find more than a few ETF’s that cover the same exposure. Even the S&P500 is covered by only a few ETF’s.

What is very interesting is that ETF issuers are moving into new and very interesting areas. Not only can you get exposure to the Chinese equity market (FXI) but you also get exposure to the currency, small caps, large caps, Chinese technology stocks, industrial or other sectors. The possibilities are almost endless. That gives investors with very precise views to make investments on those specific scenarios.

Future of ETF’s

It is unclear how ETF’s will evolve but for now they certainly look like they will continue to gain assets and market share and will force mutual fund issuers to reduce their fees much further than what they have done up until now. I do expect investors to also start paying more attention to the fees they are paying through using mutual funds. It will take time but we will get there.

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7 Comments

  1. Comment by Sustainable PF — November 24, 2010 @ 10:49 am
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    Very thorough explanation! I enjoyed the read immensely!

  2. Comment by IS — November 24, 2010 @ 11:32 am
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    @Sustainable PF- Thanks, glad you enjoyed it

  3. Comment by Catarina — November 25, 2010 @ 9:18 am
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    Back to the basics!! that’s awesome post, it’s clear. I would love to read “20 things to look at when judging an ETF” hehe ;)

  4. Comment by IS — November 27, 2010 @ 12:32 pm
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    @Catarina – You might jut get your wish:)

  5. Pingback by Best of Money Carnival — November 29, 2010 @ 12:20 am
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