Benefits Associated With ETFs
Exchange Traded Funds (ETFs) were invented in the 1990s and exploded in popularity in the 2000's. If you are new to ETFs, read our educational article what is an ETF?. Here's why they have become so popular:
1. ETFs are easy to buy and sell
ETFs trade on stock exchanges like stocks, so you can use any existing brokerage account or IRA account to buy or sell an ETF, just like you can any stock.
When you buy an ETF, you pay a commission to your broker just like you would if you were buying a stock. Many online brokers let you buy and sell certain ETFs commission free - check your broker's website for details.
2. ETFs allow you to diversify your portfolio
There are ETFs that buy stocks, bonds and commodities traded on virtually every financial market in the world.
3. ETFs appeal to people who are frustrated trying to buy and sell individual stocks and mutual funds
It's very difficult for an investor to buy and sell individual stocks in a way that will outperform the stock market as a whole. In fact, most individual investors who buy and sell stocks do substantially
worse than the market as a whole, for a variety of reasons.
Even the pros who run mutual funds and hedge funds have a difficult time buying and selling individual stocks that will outperform the market. Even when they
succeed at outperforming the market, it usually doesn't last long.
Most Mutual Funds Underperform The Market
There are lots of statistics on the internet you can find to support the case. Let's just pick one as an example. Standard & Poor's publishes an annual "SPIVA report" that measures the performance of actively managed funds against their relevant index benchmarks. The SPIVA report always show that almost 90 percent of all U.S. equities funds failed to beat their benchmarks - see our article active versus passive investing. Remember that there are some highly paid, talented people running these funds.
So it is hard for an investor to pick a "successful" mutual fund from the thousands of mutual funds that are out there. Odds are that the mutual funds that your 401k plan has chosen are also unlikely to beat the market.
It's Really Hard to Buy and Sell Individual Stocks
Longboard Asset Management completed a study called The Capitalism Distribution that examined stock returns from the top 3000 stocks from 1983-2007. They found that:
-39% of stocks were unprofitable investments.
-19% of stocks lost at least 75% of their value.
-64% of stocks underperformed the index.
-25% of stocks were responsible for all the market’s gains.
Simply picking a stock out of a hat means you have a 64% chance of underperforming a basic index fund, and roughly a 40% chance of losing money!
ETFs Offer An Alternative
Most ETFs track an "index" - a mathematical way to invest in the stock market as a whole, or in certain sectors, or certain industries, or certain countries. Once an ETF picks an index, the managers at the ETF buy and sell automatically based on the rules of the index. If you are new to indexes, read our educational article what is an index?
Most Mutual Funds Underperform The Market
There are lots of statistics on the internet you can find to support the case. Let's just pick one as an example. Standard & Poor's publishes an annual "SPIVA report" that measures the performance of actively managed funds against their relevant index benchmarks. The SPIVA report always show that almost 90 percent of all U.S. equities funds failed to beat their benchmarks - see our article active versus passive investing. Remember that there are some highly paid, talented people running these funds.
So it is hard for an investor to pick a "successful" mutual fund from the thousands of mutual funds that are out there. Odds are that the mutual funds that your 401k plan has chosen are also unlikely to beat the market.
It's Really Hard to Buy and Sell Individual Stocks
Longboard Asset Management completed a study called The Capitalism Distribution that examined stock returns from the top 3000 stocks from 1983-2007. They found that:
-39% of stocks were unprofitable investments.
-19% of stocks lost at least 75% of their value.
-64% of stocks underperformed the index.
-25% of stocks were responsible for all the market’s gains.
Simply picking a stock out of a hat means you have a 64% chance of underperforming a basic index fund, and roughly a 40% chance of losing money!
ETFs Offer An Alternative
Most ETFs track an "index" - a mathematical way to invest in the stock market as a whole, or in certain sectors, or certain industries, or certain countries. Once an ETF picks an index, the managers at the ETF buy and sell automatically based on the rules of the index. If you are new to indexes, read our educational article what is an index?
4. ETFs allow you to easily invest in commodities
ETFs have dramatically changed how investing in commodities work. You can now easily buy ETFs that track the price of:
* Precious metals like gold and silver (see #5)
* Oil, natural gas, and gasoline
* Agricultural products like corn, sugar, soy beans, and coffee
* Industrial metals like copper and aluminum
5. ETFs have dramatically changed the way people buy gold and silver
If you want to own gold and silver, one way to do that is to buy shares in an ETF that tracks the price of gold and silver. These ETFs have
exploded in popularity: gold and silver ETFs literally own hundreds of billions of dollars of gold and silver that is sitting in vaults all over the world.
When you buy shares of a gold or silver ETF, you don't technically directly own gold or silver - rather, you own shares in a fund that owns gold or
silver. But your shares really are backed by physical gold and silver sitting in vaults around the world.
6. ETFs make it easier to make money when markets are going down
As everyone has learned during the past 20 years, the U.S. stock market can go both dramatically up and dramatically down. We've suffered through
2 major stock market crashes: the dot.com bust in the late 1990's and the financial crisis in 2007/2008.
So more people have to figure out a way to make money when the market is going down! Or at least not lose so much money.
Investors have always been able to "short" a stock - bet that the price will go down. But the concept of shorting a stock has been difficult for the
average investor to understand. Plus, shorting a stock requires you to have a brokerage account that is setup as a "margin" account, which
requires you to submit extra paperwork to your broker. Also, IRA accounts are not allowed to be margin accounts and thus you can't short
a stock in an IRA.
ETFs give you a way to make money when the market is going down. There are lots of "inverse ETFs" - ETFs that will go up or down in the exact
opposite direction of the index they are tracking. If you think the S&P 500 is going to go down, you can buy SH, the ProShares Short S&P 500 ETF,
which goes up when the S&P 500 goes down. See our article what is an inverse ETF?
7. ETFs make it easier to use margin/leverage when investing
The use of margin/leverage is controversial to some people. But if you know what you are doing, the wise use of margin (i.e. using other people's money) can help you increase the return on your portfolio. The ETF industry has invented "leveraged ETFs". These are ETFs that attempt to replicate twice (2x) or even three times (3x) the performance of the underlying index they are tracking. Leveraged ETFs are easier than having a margin account (which requires you to submit additional paperwork to your broker to qualify your account as a margin), and you don't pay any interest when you own a leveraged ETF. Leveraged ETFs are popular, but they have their critics.
Keep in mind that leverage goes both ways - a 2x leveraged ETF goes down twice as fast as the index it's tracking.
Because of the effects of daily compounding, a leveraged ETF does not track it's index over longer periods of times, especially with 3x leveraged ETFs. It's vital that anyone that is thinking about buying a leveraged ETF understand that - see a discussion of this problem in our article describing leveraged ETFs.
Because of the effects of daily compounding, a leveraged ETF does not track it's index over longer periods of times, especially with 3x leveraged ETFs. It's vital that anyone that is thinking about buying a leveraged ETF understand that - see a discussion of this problem in our article describing leveraged ETFs.
8. ETFs often charge less in fees than traditional mutual funds.
Most ETFs are "passive" funds - they conduct trades systematically based on an index and thus they tend to be cheaper to operate than a traditional mutual fund that is actively managed (i.e. where a human judgementally makes every buying and selling decision). The ETF industry is very competitive right now, so the fees are dropping all the time. Current fees per our database:
| Category | ETF Count | Average Expense Ratio |
|---|---|---|
| 582 | 0.00% | |
| Alternatives | 226 | 0.45% |
| Asset Allocation | 78 | 0.70% |
| Commodities | 121 | 0.70% |
| Global Equity | 721 | 0.55% |
| Global Fixed Income | 27 | 0.39% |
| Special Security Types | 57 | 1.25% |
| US Equity | 1014 | 0.46% |
| US Fixed Income | 437 | 0.33% |
9. ETFs are usually more transparent than a mutual fund or a hedge fund
One nice thing about ETFs is that you can go to their website and find out exactly what they own. Although they are technically not required to do so, most ETFs that track an index update their list of holdings
on a daily basis. Vanguard is one notable ETF sponsor that does not do this, as they update their holdings on a monthly basis. So you can see exactly what they own, whenever you want. Remember also that they are required
to follow their index, so if you know the index they are following, you know that they can't or won't deviate from it. Actively managed ETFs are required by the SEC to disclose their holdings on a daily basis, so they are definitely more transparent than an actively managed mutual fund or hedge fund.
10. It can be easier to build portfolios using ETFs
One problem with an actively managed mutual fund is that you don't really know what types of investments the fund is going to make. Most actively managed mutual funds give their
portfolio manager the discretion of changing the types of investments the fund is making. So a mutual fund that you think is a "large cap" equity fund may suddenly skew their portfolio to mid caps,
and it is difficult to know when that happens. With ETFs that follow an index, an investor knows what he or she is getting. This makes it easier to build portfolios that are diversified in the desired fashion.
11. ETFs are usually more tax efficient than a mutual fund
An ETF that follows an index will typically not have a large amount of capital gains that must be distributed to shareholders, especially compared to an actively managed mutual fund.
Also, because of the ETF structure, ETFs often can buy and sell securities in a tax free manner, as explained in our article about ETF mechanics.
12. ETFs usually trade close to their net asset value
An ETF calculates its net asset value or NAV on a daily basis. An ETF’s NAV is the sum of all its assets (the value of its holdings in cash, shares, bonds, financial derivatives and other securities) less any liabilities, divided by the number of shares outstanding. Most ETFs trade throughout the day at market prices that are close to their NAVs, because of the way that ETFs create and redeem outstanding shares - as explained in our article about ETF mechanics.