Exchange Traded Funds have been around for a little over 25 years. They are generally seen as a simplified way to gain exposure to an entire index or sector, to be a component in an investment strategy and to diversify a portfolio. The first ETFs were designed to mimic a broadly used index like the S&P 500, for example. Since investors cannot buy an index, these type funds provide a way to gain exposure.
To understand these securities lets first look at indices, what ETFs are and then five things you should know. An index is a list of securities with a common theme averaged together and used as a representation of a market segment. The S&P 500, for example, is a gauge of large-cap U.S. equities and covers approximately 80% of available market capitalization.1 The index is reconstituted annually through a process of the Index Committee. Companies are selected based on certain criteria like market cap, being domiciled in the U.S. and being listed on a U.S. exchange.2
The Exchange Traded Fund industry’s growth has greatly accelerated over the past five years, now reaching $4 Trillion in assets.3 Most ETFs are structured to hold the same securities as the index which they emulate. Changes are made to the portfolio as the Index Committees make changes to their index. ETFs are sponsored by investment management companies and are not always connected to the sponsor of the index.
Here’s a description from the Securities and Exchange Commission “Like mutual funds, ETFs are SEC-registered investment companies that offer investors a way to pool their money in a fund that makes investments in stocks, bonds, other assets or some combination of these investments and, in return, receive an interest in that investment pool. Unlike mutual funds, however, ETFs do not sell individual shares directly to, or redeem their individual shares directly from, retail investors. Instead, ETF shares are traded throughout the day on national stock exchanges and at market prices that may or may not be the same as the NAV of the shares.” 4
1. Lower Cost
ETFs have an annual fee or expense ratio. For ETFs that are not actively managed, the expense ratio is usually lower than that of an actively managed mutual fund. In 2019 the average expense ratio of an equity mutual fund was 0.52%. By comparison, the expense ratio of an equity index ETF was 0.18%5
2. Asset Allocation
ETFs are well suited to build out an asset allocation model. They provide broad diversification to asset classes like Large-Cap Growth or Mid-Cap Value
Harry Markowitz, the father of Modern Portfolio Theory, won a Nobel Prize for his work. In his paper “Portfolio Selection” he shows that including non-correlated assets into a portfolio of stocks and bonds may reduce volatility of the portfolio.
There are commodity ETFs based on indices that can help an investor implement his theory.
3. Sector Rotation
Some ETFs track industry specific sectors as designated by GICS, Global Industry Classification Standard. There are these sectors; Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services and Utilities. 6
The economic cycle has four segments; full recession, early recovery, late recovery and early recession. A sector rotation investment strategy seeks to take advantage of changing economic conditions to find the best sector in which to invest for each phase of the economic cycle. ETFs modeled after sector indices can fill out the strategy efficiently.
4. Don’t Get Complicated
The financial industry continually creates new products with useful purposes. But, that doesn’t mean all investment products are right for just anyone. Even something designed after an index can have a few complicated versions that may not be suitable.
Imagine an ETF that bills itself as delivering 2X or 3X the movement of the index. Or one that claims to go up when the index goes down. These are called leveraged and inverse ETFs. Warren Buffet’s quote “Risk comes from not knowing what you are doing” comes to mind.
The SEC and FINRA (Financial Industry Regulatory Authority) issued a joint statement on leveraged and inverse funds warning that “Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis. Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.” 7
These types of ETFs may work well in specialized situations, but may not be well suited to hold long term.
5. More Than Just Equities
Yes, there are bond and fixed income ETFs, too. Though these types of ETFs hold bonds, they trade on a stock exchange. This gives greater transparency in pricing than the traditional bond market. But, it comes with other limitations. The investor holds an indirect interest in the underlying bonds unlike holding an individual bond to maturity. Nevertheless, they serve as an excellent way to get exposure to fixed income securities in a broad and diversified manner.
Contact me at email@example.com to discuss how ETFs may help you reach your goals.
1 S&P Global website
2 S&P U.S. Indices: Index Methodology, May 2020, S&P Global
3 CFRA (Center for Financial Research and Analysis)
4 “Mutual Funds and ETFs, An Investor Guide” Securities and Exchange Commission Office of Investor Education and Advocacy, SEC pub 182
5 Trends in the Expenses and Fees of Funds, 2019, Investment Company Institute, ICI Research Perspective, March 2020, Vol. 26 No. 1
6 University of New Mexico publication of Standard & Poor’s “Global Industry Classification Standard (GICS®) August 2006
7 SEC-FINRA Investor Alert on Leveraged and Inverse ETFs “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors” Aug. 18, 2009
Securities and advisory services offered through Madison Avenue Securities LLC (MAS) Member FINRA/SIPC and a Registered Investment Advisor; MAS and PFS Wealth Management Group are not affiliated companies. MAS does not provide legal and tax advice. Seek competent legal and tax counsel for your specific needs
This is for informational purposes only and may not be indicative of your situation. ETFs are subject to investment risk similar to those of stocks including those regarding short-selling, margin account maintenance and possible loss of principal. It is not possible to invest in an index.