I believe Exchange Traded Funds are the most important innovation in the investment world in the past 30 years. Yet many investors, especially those who don’t read financial publications or watch financial news channels regularly, may be unfamiliar with them. So here’s a brief primer on Exchange Traded Funds or ETFs, as they’re commonly called.

ETFs can be thought of as the child of a marriage between a mutual fund and a stock. Like a mutual fund, ETFs offer investors a proportionate share in a professionally managed portfolio of securities, such as stocks or bonds. As such, they offer many of the advantages of mutual funds, including Diversification (see the article on Diversification on our website) and Professional Management.

In addition, like Index mutual funds, the vast majority of ETFs are also designed to track specific indexes. This provides the additional advantage of Low Expense Ratios (more on that later).

Like stocks, on the other hand, ETF shares are traded on an exchange, which means that unlike mutual funds, their shares can be bought and sold during the trading day. Mutual fund shares can only be purchased or redeemed at the end of the trading day, after the markets have closed.

How Do ETFs Work?

Mutual fund shares are generally bought and sold directly from the fund at each share’s Net Asset Value or NAV (the total value of all the securities in the portfolio divided by the total number of shares in the fund), determined at the close of the market each day. In a mutual fund, most transactions are conducted in cash. With rare exceptions, investors purchasing fund shares pay cash to the fund, while those redeeming shares receive cash from the fund, which may require the fund manager to buy or sell securities in the portfolio. When the fund trades securities, it incurs transaction costs such as brokerage commissions, and in some cases, it realizes capital gains on which shareholders will owe taxes.

With ETFs, only certain sophisticated institutional investors (brokerage houses, for example) are authorized to purchase or redeem shares directly, and they do so almost exclusively with securities.

When these institutional investors purchase shares of an ETF, they give the ETF specific quantities of securities that are part of the index the ETF tracks. Similarly, when these institutions redeem their ETF shares, the ETF provides them with securities, not cash. These cashless transactions benefit the ETF in two ways: The ETF does not incur transaction costs or realize capital gains. Institutional investors sell their ETF shares to individual investors on the open market, who may then sell their shares to other investors for cash. These market trades, however, have no effect on the ETF itself; no cash flows into or out of the ETF that would require it to purchase or sell portfolio securities, pay brokerage commissions, or realize capital gains. As a result, the ETF is able to hold down its operating costs and limit the distribution of taxable gains to shareholders.

Why We Like ETFs

We’ve already discussed some of the positive features ETFs have, such as

• Diversification
• Professional Management
• Low Expense Ratios
• Intra-day Trading
• Tax Efficiency

There’s one more advantage, often referred to as Transparency. Because of their unique creation and redemption mechanism, ETFs must generally disclose their holdings on a daily basis. This enables ETF investors and their Advisors to know exactly what they are investing in. Mutual funds, on the other hand, are only required to disclose their holdings periodically, usually quarterly or semi-annually. And often by the time those reports are produced, they are out of date.

Disadvantages of ETFs

ETFs do have certain drawbacks, including the fact that there are trading costs associated with buying and selling their shares. These costs include:

• Brokerage Fees – Fees or commissions charged by a brokerage firm to execute the ETF trade. For example, the broker we use to custody client securities charges $7.95 per trade for most trades (if the client elects to receive statements and confirmations electronically). Other firms may charge more, or less.

• Bid/Ask Spreads – This is the difference between the price the buyer is willing to pay (Bid) and the price for which the seller is willing to sell (Ask). For many actively traded ETFs, these spreads are very small – 1 or 2 cents per share – but for more infrequently traded ETFs they can be larger.

• Premium/Discount – Since ETF shares are bought and sold among investors in the open market and not directly from the fund, the price at which the shares are bought or sold may vary from the NAV (net asset value) of the fund. If the purchase price is higher than the NAV, the fund sells at a Premium; if lower, the fund sells at a Discount. It’s possible to buy shares at a Premium and sell them at a Discount, which would be a negative for the investor (of course, the reverse is also possible, which would benefit the investor).

However, all of the above costs are one-time costs – incurred only when shares are bought or sold. The huge advantage of ETFs – their phenomenally low Expense Ratios, are a benefit that continues for as long as the investor holds the shares.

ETF Expense Ratios

The Expense Ratio of a mutual fund or ETF is a key part of the cost investors pay. It represents the percentage of a fund’s total assets the fund spends on expenses, such as employee salaries, sales commissions, compensation to fund managers, transaction costs, etc. And that’s money you don’t get as an investor in the fund. For example, if a fund’s underlying investments return 10% in a given year but the fund has a 2% Expense Ratio, you will end up with only an 8% return.

That may not sound bad, but if the fund’s investments only earn 2% in a given year, you’ll earn zero. The Expense Ratio is a direct hit against your return.

Index mutual funds, which track a specific index (such as the S&P 500, for example) typically have much lower Expense Ratios than other mutual funds which try to beat the market averages (called Actively Managed funds). The Expense Ratio for many popular ETFs can be 0.1%, or even lower. By contrast, some Actively Managed mutual funds have Expense Ratios of 1.5%, or even higher.

If that difference doesn’t seem like much, consider this – the difference between 1.5% and 0.1% is 1.4%. For a $100,000 portfolio, that difference means you’d have over $23,300 less at the end of 10 years in the portfolio with the higher Expense Ratio (assuming a 6% annual return).

That’s why the one-time costs of ETFs are usually dwarfed by their advantage over mutual funds in lower Expense Ratios over the long term. Of course, if you trade ETFs frequently, you won’t reap those advantages. But we believe in long term, low cost investing and infrequent trading. And if ETFs are used in that way, they can provide a significant benefit.

Exotic ETFs

There are now more than 1,400 ETFs and more are being created all the time. Some of these are considerably more risky than others. For example, some ETFs use borrowing or short selling to provide returns that are the inverse of an index while others try to multiply the return of an index by 2 or 3 times – that is, if the index is up 10% a 2X leveraged ETF linked to that index would be up 20%. There are also ETFs that invest in only one sector or only one country. In general, we avoid the use of inverse and leveraged ETFs entirely and use sector or country ETFs only sparingly.