What are Exchange Traded Funds?

Investing
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By Robert Riedl, CPA, CFP, AWMA

Learn more about Robert on NerdWallet’s Ask an Advisor

As their name suggests, exchange-traded funds (ETFs) are investment funds that trade openly on the stock exchange. Although they have become increasingly popular of late, ETFs have actually been around since the late 1970s.ETFs are structured similarly to mutual funds in that each share that an investor purchases represents partial ownership of an underlying group of securities. Investors in both mutual funds and ETFs can achieve diversification through a single purchase. However, ETFs can be bought and sold on an exchange throughout the day, whereas mutual funds can be bought or redeemed from the mutual fund company only after the close of trading. Thus, ETFs combine the diversification potential of a broad portfolio with the simplicity of trading a single stock on an exchange.

The first ETF was designed to track the performance of the S&P 500. And the majority of ETFs on the market today stay true to their passive “indexing” heritage—tracking specific indexes in the attempt to “be” the market, rather than beating it.

However, in an effort to outperform the market, some managers create specific parameters, screens or weightings when selecting securities for their ETFs. For example:

  • A fund manager might start with the S&P 500 Index but choose only those stocks with the highest dividend yields.
  • Another manager may create a basket of securities to invest in assets not typically covered by an index—such as currencies.

These managers are, in effect, combining elements of active and passive investing by actively creating their portfolios, which are then more passively managed on a day-to-day basis.

ETFs differ most significantly from mutual funds in the way they are bought and sold. ETFs behave like stocks, and investors can buy or sell shares at any time throughout the day. Like stocks, ETFs also offer flexible trading options, such as stop and limit orders (a stop order sets a specific price at which ETF shares are to be purchased or sold, while a limit order sets a maximum or minimum price at which you are willing to buy or sell ETF shares, respectively) and the potential for such tactical hedging strategies as selling short (borrowing ETF shares to sell now in the hopes that you can buy them back more inexpensively later) or on margin (taking out a loan to buy ETF shares, or using ETF shares as collateral in an effort to leverage your existing portfolio beyond your initial investment).

Another potential advantage of ETFs is that, unlike many mutual funds, they typically have no sales charges. Plus, like most index funds, they generally offer low management fees. However, there are trading costs associated with an ETF, as there are for stocks. In many cases, low fees and expenses can outweigh trading costs, but this will depend on how frequently and in what quantity an investor trades.


ETFS OFFER A NUMBER OF POTENTIAL BENEFITS THAT CAN MAKE THEM EXTREMELY EFFECTIVE FOR HELPING INVESTORS REACH SPECIFIC LONG-TERM GOALS:

  • Diversification
  • Low fees and no sales load
  • Intraday liquidity
  • Tax efficiency
  • Transparency—and much more

ETFs come in every style and asset class in the investment rainbow. They can help investors generate income, achieve long-term growth, gain more complete diversification—and much more.
ETFs offer a number of benefits that can make them extremely effective in helping investors reach specific long-term goals. Additionally, as with mutual funds, ETFs come in every style and asset class in the investment rainbow. They can be used to complement mutual funds in an existing asset allocation, to replace mutual funds—or for an entire portfolio.

CORE AND SATELLITE INVESTING APPROACH

Core/satellite investing is a method of portfolio construction designed to minimize costs, tax liability and volatility while providing an opportunity to outperform the broad capital market as a whole. The core of the portfolio consists of passive investments that track major market indexes, such as the Standard and Poor’s 500 Index (S&P 500) and/or the Barclays Capital Aggregate Bond Index. Additional positions, known as satellites, are added to the portfolio in the form of actively managed investments. The conventional view of the core-satellite methodology suggests it is prudent to use index funds for markets that are deemed efficient and to use active managers in areas considered to be inefficient, where the managers are presumed more likely to succeed.


ALPHA VS. BETA

When an investor separates a single portfolio into two portfolios, an alpha portfolio and a beta portfolio, he or she will have more control over the entire combination of risks to which he or she is exposed. By individually selecting your exposure to alpha and beta, you can enhance returns by consistently maintaining desired risk levels within your aggregate portfolio. Understanding the following terms will help in understanding the difference between alpha and beta sources of risk:

Beta – The return generated from a portfolio that can be attributed to overall market returns. Exposure to beta is equivalent to exposure to systematic risk (see below). The alpha is the portion of a portfolio’s return that cannot be attributed to market returns, and is thus independent from market returns.

Alpha – The return generated based off of idiosyncratic risk (see below).

Systematic Risk – The risk that comes from investing in any security within the market. The level of systematic risk that an individual security possesses depends on how correlated it is with the overall market. This is quantitatively represented by beta exposure.

Idiosyncratic Risk – The risk that comes from investing in a single security (or investment class). The level of idiosyncratic risk an individual security possesses is greatly dependent on its own unique characteristics. This is quantitatively represented by alpha exposure. (Note: A single alpha position has its own idiosyncratic risk. When a portfolio contains more than one alpha position, the portfolio will then reflect each alpha position’s idiosyncratic risk collectively.)

Alpha and beta expose portfolios to idiosyncratic risk and systematic risk, respectively; however, this is not necessarily a negative thing. The degree of risk to which an investor is exposed is correlated to the degree of potential return that can be expected.


ACTIVE VS. PASSIVE

Active investing means trying to beat the market over a particular time period using one or both of the following strategies:

Security selection. This is a fancy term for buying the right stocks (or bonds, or funds, or any other asset) and avoiding the wrong ones. It means having the foresight to buy Apple in the pre-iPod days and not to buy Netflix on the day after its IPO.

Market timing. Markets gyrate. If you can correctly predict those gyrations ahead of time, you can make a lot of money—or avoid losing it.

Passive investing means doing neither of those things. It means diversifying as much as possible by buying broad market index funds. It means owning the next Apple, but also the next Groupon. And it means not trying to time the market. That means staying in when stocks take a dive five days—or months, or years—in a row.Passive investing also means making portfolio decisions based on personal circumstances, not on headlines or research.Passive management, or indexing, has been gaining greater acceptance as an investment approach among investors. This acceptance has come in no small part because numerous academics and financial publications have been quick to point out that investment managers do not consistently beat the market, i.e., regularly outperform a relevant index such as the S&P 500 or Russell 2000 Indexes or an index-based passive strategy.

Active and passive investments do not need to be mutually exclusive. Just as allocations to the developed and new growth markets, or to equities and bonds, can be complementary, we believe that active and passive investments can serve different needs in the same portfolio. Over the past decade, we have seen periods of extreme macro-driven equity performance, the proliferation of index investment options and numerous articles favoring passive management. Increasingly, investors have been presented with the argument—why not just go passive? While we believe that passive investing has its benefits there are several variables, such as time horizon and index distortion, that investors should consider before making a decision. In our view, investors seeking to make a strategic allocation to equities should obtain a more nuanced understanding of both active and passive approaches to determine their optimal investment strategy.


STRATEGIC ASSET ALLOCATION VS. TACTICAL ASSET ALLOCATION

Strategic asset allocation calls for setting target allocations and then periodically rebalancing the portfolio back to those targets as investment returns skew the original allocation percentages. The concept is akin to a “buy and hold” strategy, rather than an active trading approach. Of course, the strategic asset allocation targets may change over time as the client’s goals and needs change and as the time horizon for major events such as retirement and college funding grow shorter.

Tactical asset allocation allows for a range of percentages in each asset class (such as Stocks = 40-50%). These are minimum and maximum acceptable percentages that permit the investor to take advantage of market conditions within these parameters. Thus, a minor form of market timing is possible, since the investor can move to the higher end of the range when stocks are expected to do better and to the lower end when the economic outlook is bleak.