Introduction: Why the Growth in Exchange-Traded Funds?

The purpose of this book is to help investors understand and use exchange-traded funds (ETFs).5 Introduced just some 25 years ago, ETFs are now one of the fastest-growing segments of the investment management business. This book covers the details of how ETFs work, their unique investment and trading features, and how they fit into portfolio management. It also covers how best to evaluate ETFs to identify the right funds to fit any particular investment or trading objective.

Exchange-traded funds provide liquid access to virtually every corner of the financial markets, allowing investors big and small to build institutional-caliber portfolios with management fees significantly lower than those typical of mutual funds. High levels of transparency for both holdings and the investment strategy help investors easily evaluate an ETF’s potential returns and risks.

At their core, ETFs are hybrid investment products, with many of the investment features of mutual funds married to the trading features of common stocks. Like a mutual fund, an investor buys shares in an ETF to own a proportional interest in the pooled assets. Like mutual funds, ETFs are generally managed by an investment adviser for a fee and regulated under the Investment Company Act of 1940. But unlike mutual funds, ETF shares are traded in continuous markets on global stock exchanges, can be bought and sold through brokerage accounts, and have continuous pricing and liquidity throughout the trading day. Thus, they can be margined, lent, shorted, or subjected to any other strategy used by sophisticated equity investors.

Although some other kinds of mutual funds—traditional closed-end funds, in particular—also trade on an exchange, today’s ETFs are different. They typically disclose their holdings at the start of every trading day, so potential buyers and sellers can evaluate the traded ETF price versus the price of the underlying holdings. Specialized traders can create and redeem shares at the end of the day for net asset value, a feature that helps keep ETF market prices aligned with “fair value.”

[drizzle]As of the end of Q1 2014, there were 1,570 ETFs listed in the United States, with a total of almost $1.74 trillion in assets under management. In 2013, ETFs represented more than 11% of all mutual fund assets, up from 2% a decade earlier, and they continue to attract both individual and institutional investor assets. Even more impressive, on any given day, ETFs typically represent between 25% and 40% of the total dollar volume traded on US exchanges.

In short, in 20 years, these innovative financial products have gone from an afterthought to one of the most important forces shaping how investors invest and how the market itself functions. The outlook for continued growth is strong. For the four years ending 2013, ETFs attracted, respectively, $188 billion, $188 billion, $119 billion, and $122 billion in net inflows. At the end of Q3 2013, almost 1,000 new ETFs were registered at the US SEC. Recently, such mutual fund giants as PIMCO have moved aggressively into the ETF space and other firms, including Fidelity, T. Rowe Price, and Janus, have filed papers with the SEC to do the same. Experts ranging from BlackRock to McKinsey & Company expect overall assets to double in short order. In Chapter 14, we address the future of ETFs in detail in terms of investor applications and product development.

Benefits of Using ETFs as Investment Vehicles

An analysis of the ETF market must start with the central question: What are the features of ETFs that have made these funds so successful?

Costs and Benefits of Index Strategies. Ask most investors why they own ETFs, and the first answer they will give is lower cost. The average mutual fund investing in US equities had an expense ratio of 1.37% in 2013, whereas the average US equity ETF expense ratio was 0.45%. ETFs now routinely offer exposure to broad areas of the markets at extraordinarily low costs: As of Q1 2014, an investor could gain exposure to a broad cross section of US equities for as little as 0.04% per year; emerging market equities cost as little as 0.14%.

The cost savings come, first and foremost, from the fact that most ETFs are index funds and, therefore, do not bear the costs of discretionary, active portfolio management. But index ETFs tend to be cheaper even than indexed mutual funds for investors operating at the retail level. (The story is mixed for institutional investors or those with separately managed accounts of significant size.)

Why the savings?

The primary reason for ETFs’ cost advantage is implied by their name: The funds are exchange traded. When you buy or sell an ETF as an individual investor, you do so through a broker on an exchange. The costs of recording who you are, sending you prospectus documents, handling inquiries, and other factors are all borne by the broker. From the ETF manager’s point of view, it only has a handful of “customers”—the brokerage firms where client accounts are kept.




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