Exchange-Traded Funds (ETFs)
An exchange-traded fund (ETF) is a basket of securities that may consist of stocks, bonds, commodities, or other financial assets. In most cases, ETFs are trying to match the performance of a specific passive benchmark. According to Morningstar, the global ETF market is $9.1 trillion in size (August 2021). Most ETFs in the U.S. are structured as open-end investment companies, and advisors and investors can buy or sell ETF shares just as they would shares of a publicly traded company.
ETFs have transformed the investment industry over the past two decades, and today, they are the fastest growing investment vehicle. Over time, ETFs have gained wide acceptance as vehicles that combine the low cost and simplicity of index mutual funds with the liquidity and flexibility of individual stocks. In response to the pandemic-induced market collapse in March 2020, the Federal Reserve deployed billions of dollars to support the bond market. The move was historic and notable because the Federal Reserve purchased ETFs. The central bank saw ETFs as a quick and efficient way to gain access to the U.S. bond market. Furthermore, the CBOE reported that ETFs made up nearly 40% of trading in March 2020.
ETFs have many advantages. The most prominent advantages are trading flexibility, portfolio diversification, tax efficiency, and lower costs.
Flexibility
Unlike mutual funds, which are priced once at the end of the day, ETFs can be traded anytime during trading hours. ETFs provide more flexibility in trading and better price transparency. ETFs are versatile because an investor can gain access to a breadth of stocks and bonds and various sub-asset classes. When owning an ETF, there is complete transparency because the underlying components are disclosed every trading day.
Diversification
Systematic risk is a non-diversifiable risk that investors assume when investing in the financial markets. Think of it as a risk that cannot be controlled and is caused by natural disasters, changes in government policies, wars, and any other event that cannot be planned for. Systematic risk can be partially mitigated by asset allocation. Owning different asset classes with low correlation can lower this risk because asset classes generally react differently to macroeconomic factors.
Unsystematic risk is unique to a specific company or industry. This is risk attributable to a specific investment or a small group of investments. It is uncorrelated with overall financial market returns. Examples of risk that are specific to individual companies or industries are credit risk, product risk, legal risk, liquidity risk, operational risk, and political risk.
ETFs can nearly eliminate unsystematic risk because they inherently provide instant diversification across an entire asset class. If an investor owns just one stock or bond and it suffers an adverse effect, the investor will suffer great harm. However, if an investor owns a basket of securities in a particular asset class, the damage to the investment portfolio will be minimized. By utilizing ETFs, unsystematic risk can be nearly eliminated.
Tax Efficiency
ETF tax efficiency has two main drivers. The first arises from strategy, the second from structure. ETF strategy generally leads to low turnover since 97% of ETF assets are in passive funds that track an index. Any adjustments in the composition of index ETFs underlying holdings will be driven by index changes, which in turn are a result of normal index rebalancing, corporate actions (e.g., mergers and acquisitions), and reconstitution (adding or removing a stock from the index).
An ETFs structure is distinct from a traditional mutual fund structure. ETFs have a unique in-kind creation and redemption mechanism by which ETF shares are brought into and removed from the market. Unlike mutual funds, ETFs do not sell holdings in exchange for cash, which would cause a taxable event. Instead, ETFs undergo a creation and redemption process in which market makers and authorized participants swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa. The differences between how ETF shares and mutual fund shares are created and redeemed have important implications when it comes to taxes. This in-kind process doesn’t create a taxable event.
Tax-efficiency does not mean tax-exempt. Investors in ETFs will still pay taxes on income and dividends, and they will still be responsible for capital gains taxes when an ETF is sold for more than it cost. ETFs will sometimes distribute capital gains, though usually with less frequency and smaller than those generated by active funds.
Federal Reserve Bank of Boston: The Shift from Active to Passive Investing. Working Paper May 15, 2020.
Lower Cost
No one can control the financial markets. But investors can control what they pay for investment costs. The compounding effect of costs on your wealth could be dramatic over time. Average ETF fees in the U.S. have tumbled around 40% over the last eight years, and the major providers continue to lash fees every year. Many of the bellwether ETFs currently have annual expense ratios in the 0.03%-0.13% range.