ETFs and Mutual Funds

A client recently confided to me that he did not understand ETFs. These are exchange-traded funds. To understand why ETFs are so popular today, let’s examine why they were created as an alternative to mutual funds.

Mutual funds were created to allow someone to purchase one security that represented a basket of securities. Mutual funds were invented to provide investors with risk diversification. Instead of buying one security, investors were able to buy a basket of securities so that if one security went down in price, others in the basket could go up. In that way, the investor’s risk of loss was diversified. But, then mutual funds began to proliferate.

Thousands of mutual funds were created, many with the same securities in the baskets. And, because the mutual funds were managed and the managers wanted the fund to be attractive to investors, it was not uncommon for the fund manager to engage in excessive buying and selling within a basket of securities. This is called portfolio turnover. High portfolio turnover is a measure of risk. It may also trigger unwanted tax effects for investors, some of whom have been required to pay capital gains tax on underperforming mutual funds.

Mutual funds are managed funds – that is, a fund manager chooses the securities to go into a fund or securities to sell, etc. The investor pays for the management of the mutual fund, so mutual funds are more costly.

Mutual funds price the securities in the basket everyday at 4:00 p.m. There is no trading over any exchange of a mutual fund – securities are simply priced once a day.

All of these issues with mutual funds – the inability to trade them during a day, possible tax issues, and cost of the funds caused some in the financial industry to create a new type of security called an “exchange traded fund” or ETF.

Most ETFs are based on an index. So, let’s say you want to purchase a security that is comparable to the S&P 500. You can buy an ETF that holds securities that mimic the S&P 500. When the S&P goes up, your S&P ETF goes up and the reverse is true.

ETFs are not managed so there is no management fee built into the cost of the security. That means ETFs are less expensive. Also, since the ETFs are traded on the exchange you can buy and sell them all day long. They do not price at 4pm like mutual funds. And, more added benefits. You can “short” ETFs which you cannot do with mutual funds.
Suppose, for example, that you think the S&P will drop in value. “Shorting” is the term given when you sell a security you do not own, thinking you will make money by buying it to deliver at a price less than you sold it for. Suppose you sell the S&P 500 ETF at $100. You know you are required to deliver the underlying security to the buyer within three days. If the market drops as you predict and the S&P goes to $80, you can buy the ETFs you need to deliver to the buyer in the market at $80, thus making $20 on the trade.

Finally, there will be fewer tax surprises with ETFs. ETFs deliver greater tax efficiency with lower portfolio turnover. As a product, ETFs have become wildly popular because of their flexibility and lower cost. In terms of creating a diversified portfolio of securities, which is mandatory to succeeding in investing, ETFs offer specialized products that fill a niche in lieu of buying specific securities. Asset managers all over the world now use ETFs for individual portfolios, pensions, endowments and sovereign wealth funds.

Remember, any investing involves risk, including loss of principal. Educating yourself on types of investments is your best approach to minimizing risk.

Lyn & TeddyAbout the Author: Lyn Striegel is an attorney in private practice in Chesapeake Beach and Annapolis. Lyn has over thirty years experience in the fields of estate and financial planning and is the author of “Live Secure: Estate and Financial Planning for Women and the Men Who Love Them (2011 ed.).” Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel.