This article was published in the New Haven Register on April 15, 2017
The first exchange-traded fund was listed in 1990 in Canada, three years before the first United States-based ETF came on the scene. In the ensuing 27 years ETFs have become the fastest-growing segment of the investment industry. Today there are about 2,000 ETFs in the United States alone and 5,000 worldwide, and they are attracting record inflows nearly every month.
Yet many investors haven’t included ETFs in their portfolios, partly because they don’t understand them. Investors are much more familiar with mutual funds, which date to 19th century Europe: Their popularity exploded in the 1980s and 1990s, especially in the United States.
ETFs have become increasingly popular because they offer certain benefits over traditional mutual funds. Like any investment, however, they also carry their own risks.
ETFs are hybrid products that resemble mutual funds but are traded like individual stocks. As with a mutual fund, when you invest in an ETF you buy shares in a pool of assets that are invested in a basket of securities. This offers investors a way to diversify at low cost and with minimal effort.
ETFs also are usually managed by institutional advisers for a fee, like mutual funds. However, the majority of ETFs track indexes so they are passively managed, resulting in lower fees than actively managed mutual funds. Of course, the mutual fund industry has also gone down the path of passive management, so many mutual funds also offer low fees today. Still, ETFs offer further cost savings because they are exchange traded, meaning the broker pays the costs associated with administering the funds.
The main difference between ETFs and mutual funds is that ETFs are traded like stocks, continuously throughout the day at prices that change based on demand. Mutual funds, by contrast, trade only once a day at one price, after the markets close. ETF investors benefit from lower share prices and higher liquidity and from increased access to asset classes that were previously more difficult to own, such as currencies, emerging-market bonds and a variety of costly alternative assets.
ETFs also tend to be more tax-efficient than mutual funds, because of the way they are structured and because ETF managers make fewer trades on average. About half of mutual funds pay out taxable capital gains annually to shareholders, compared with a fraction of ETFs.
Of course, ETFs also have potential downsides. Investors can incur brokerage commissions when they buy and sell ETFs, for instance. This can be a real issue for investors who are attracted to ETFs because they are traded like stocks.
Along the same lines, an investor who is attracted to ETFs because they provide access to exotic trading strategies or uncommon, alternative investments may subject themselves to higher investment risks. A financial planner can help you sort through these issues.
ETFs can be a low-cost, flexible method to gain exposure to a wider variety of investments and can play an important role in portfolio diversification, financial planning and retirement planning. As with most investments, they are generally most suited for investors with a long-term outlook rather than investors interested in frequent trading of assets.
Investors should carefully consider the investment objectives, risks, fees and expenses before investing. For this and other important information please obtain the investment company fund prospectus and disclosure documents from your rep/adviser. Read this information carefully before investing. Investing involves risks. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal.