Exchange Traded Funds

I wanted to write about something year end related or maybe something related to the holidays. Then I met with not one, not two, but THREE clients who derogatorily said “yea, but they are ETFs…” when we discussed potential changes in their accounts. Therefore, this month is a crusade to educate on what an Exchange Traded Fund (referred to as an ETF) is. With that, how about we start with two big things you may not know about ETFs?

1. They aren’t just index funds anymore. I’ve heard people express that ETFs are just as overly diversified as mutual funds and can water down your returns as a result. Let’s start by saying, some of the first ETFs were products designed to mimic broad market indexes. However there are now hundreds of ETFs that range from index funds, to sector specific funds, to cross sections of indexes based on market capitalization, and with many other strategies and goals. Some even use custom indexes to benchmark against. Want to buy real estate, but can’t handle the liquidity issue it presents? There is an ETF for you. Want to buy into social responsible companies only? There is an ETF for you. This brings us to number 2.

2. The fees are lower than mutual funds because they are passive. Yes, mutual funds can be actively managed and ETFs still haven’t gained much traction in actively managed approaches. ETFs can be actively bought and sold by an adviser though and often the fee for hiring the adviser plus the fund fee is STILL less than the mutual fund. The reason ETFs have lower fees has nothing to do with management style and everything to do with how the products are created and offered. A mutual fund is a pool of money and you buy into that pool directly from the fund company. They have administration, operations, and other expenses they have to cover in addition to asset selection. An ETF is created by the fund creator and sold in a “Creation Unit” to an “Authorized Participant” which is a financial institution like a broker-dealer. Then the authorized participant can either keep those assets within the creation unit, or break up the unit into tens of thousands of shares in the ETF and sell it on exchanges to individual investors like you and I. This exchange of creation units between the ETF creator and the authorized participant makes the costs of creating shares in an ETF way lower than creating shares in a mutual fund and those savings are passed on to the investors in the form of lower expense ratios.

We went into a few more technical terms than I like to in this post. Hopefully I didn’t lose you and you learned something! ETFs can be used very effectively in a portfolio. They may not be of interest to you, but they can be very valuable to many investors from those just starting out to those well into retirement.

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