But achieving financial security is not easy. A 2015 Pew Research Poll suggests that more than half of Americans are not financially prepared for the unexpected, or otherwise spend more than they make each month. 8 of 10 Americans worry about their lack of savings. At the same time, most Americans recognize that regularly saving and investing a portion of their income is the foundation of financial security. While savings accounts are a critical component in an investment plan with their low risk and high liquidity, most investors need the higher potential returns of equity ownership.
The Evolution of Equity Investment Vehicles
Portfolios of Individual Stocks
After World War II, Merrill, Lynch, Pierce, Fenner & Beane (the predecessor to Merrill, Lynch, Pierce, Fenner & Smith, Inc.) initiated a campaign to “bring Wall Street to Main Street” that included pamphlets and seminars teaching the public how to invest in the common stocks of America’s corporations. By 1947, the company was responsible for 10% of the transactions on the New York Stock Exchange; three years later, it had become the largest brokerage firm in the world. Wall Street firms encouraged investors to own stocks of individual companies, promoting investment clubs and Monthly Investment Plans. The public eagerly responded to the new investment, driving annual volume on the NYSE from 377.6 million shares in 1945 to over a billion shares by 1961, according to NYSE Market Data.
Despite the success, many potential investors had limited capital or lacked the time or expertise to successfully analyze or monitor the stock market. These deficiencies led to a demand for professionally managed portfolios that could be shared by hundreds of investors for reduced costs, investment risk, and volatility: the mutual fund.
Professionally-Managed Portfolios – Mutual Funds
In 1928, the Wellington Fund – the first mutual fund to include stocks and bonds – appeared. Within a year, there were 19 open-end funds and about 700 closed-end funds, the majority of which were wiped out in the Wall Street Crash of 1929. When America’s economy boomed in the 1950s, interest in pooled, professional management of stock portfolios – mutual funds – resurfaced. A mutual fund is often defined as a basket of stocks, bonds, or other assets. It’s managed by an investment company for investors who don’t otherwise have the resources to buy or manage a collection of individual securities themselves.
Demand for the new investment vehicle exploded. Gene Smith, writing for The New York Times on October 6, 1958, claimed, “The butcher, the baker, the candlestick maker, the cop on the beat, the housewife – all have one thing in common today: they’re pouring more and more dollars into mutual funds.”
According to the Investment Company Fact Book, the net purchases by households of mutual fund shares exceeded the purchase of corporate stock shares for the first time in 1954. And by the end of 2014, households held almost $12.5 trillion of mutual funds of different types (equity, bond, and balanced).
Index Tracking Mutual Funds
However, even as investment in mutual funds increased, some began to question whether the performance justified the high fees of management. The claims by many mutual fund managers that their results exceeded general market returns were exaggerated, particularly over multiple market cycles. According to the S&P Dow Jones Indices 2014 Scorecard, 86% of large-cap fund managers under-performed the S&P 500 that year. And Morningstar found that investors cashed in $92 billion from actively managed funds and added an additional $160 billion to invest in index funds in 2015 alone.
Index funds – a mutual fund that holds all of the stocks constituting a particular stock market measure – became available to the public in 1974 when John Bogle created the Vanguard 500 Index Fund, designed to track the Standard & Poors 500 Stock Index. Bogle, recognizing the difficulty of trying to consistently out-perform the market, advocated a new approach to investing in his “The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns” with the advice, “Don’t look for the needle in the haystack. Just buy the haystack.”
Index funds are similar to other open-ended mutual funds. For instance, they are purchased and redeemed directly from the management company and do not trade on an exchange. However, index fund management fees are significantly reduced due to a lower need for expensive research (most buy and sell decisions are computer-driven). While index funds meet the needs of some investors, the quest for lower costs, increased liquidity, and enhanced investment flexibility have led many investors to prefer exchange traded funds, or ETFs.
An ETF is similar to an index mutual fund in that it also follows an index (it’s not actively managed). However, unlike an index fund, an ETF trades like common stock on an exchange and can be bought or sold throughout the day. As a consequence, ETFs have a number of options not present in mutual funds, including the ability to purchase shares on margin or make short sales, whether for speculation or hedging.
Created in January 1993 by State Street Global Advisors, the SPDR S&P 500 (SPY) was the first ETF in the United States. The fund is designed to track the Standard & Poor 500 Index, a composite of the market capitalizations of 500 large companies listed on the New York Stock Exchange (NYSE) or Nasdaq. According to ETFdb.com, SPY has more assets under management than the next three largest ETFs together.
Like an index mutual fund, the composition of an ETF is designed to track specific security indexes or benchmarks such as the S&P 500, the Russell 2000, or Morningstar Small Value Index. Exchange traded funds are available in multiple categories, including:
- United States Market Indexes. These ETFs track such indexes as the S&P 500, Dow Jones, Nasdaq-100, or CRSP US Total Market.
- Foreign Market Indexes. Some ETFs track other countries’ stock indexes such as the Japanese Nikkei Index or the MSCI Germany Index.
- Sectors and Industries. ETFs are available that track a particular industry or sector of the economy such as pharmaceuticals (PowerShares Dynamic Pharmaceuticals ETF – PJP) or biotechnology (iShares NASDAQ Biotechnology Index ETF – IBB). Other sectors include consumer goods, utilities, and high tech.
- Commodities. These ETFs track the price of specific commodities such as gold(GLD) or oil (USO).
- Foreign Currencies. Some ETFs track a specific currency against the U.S. dollar, such as the Japanese yen (FXY), or a basket of currencies against the dollar, such as the eight currency markets of Asia (AYT).
- Market Capitalization. These ETFs include indexes based upon large, medium, and small capitalizations, such as the Vanguard Total Stock Market ETF (VTI), SPDR MidCap Trust Series I (MDY), and PowerShares Fundamental Pure Small Growth Portfolio (PXSG).
- Bonds. Choices include international, government, or corporate bond-based ETFs, and include funds like the SPDR Capital Long Credit Bond ETF (LWC).
This type of investment has proven to be very popular with institutional and individual investors; thus, the Investment Company Institute (ICI) listed more than 1,400 ETFs with assets of nearly $2 trillion by 2015. 5.2% of American households owned shares of ETFs in mid-2014, with more than one-quarter in ETFs concentrated in the stocks of large-cap domestic companies. According to the ICI, ETFs have attracted almost twice the flows as indexed mutual funds since 2007, as investors sold traditional mutual funds and reinvested in indexed alternatives.
Superior Market Performance of Index Funds & ETFs
While the goal of every investor and portfolio manager has been to beat the market (in other words, have investment returns greater than the broad market averages), the reality is that few, if any, can consistently deliver exceptional gains. Economists and investment professionals recognize the futility of such efforts and recommend the purchase and holding of index funds.
According to Warren Buffett, “Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net result [after fees and expenses] delivered by the great majority of investment professionals.” Charles Ellis, Ph.D., author of “Winning the Loser’s Game” and a past chairman of the Institute of Chartered Financial Analysts, agrees, writing, “The long-term data repeatedly document that investors would benefit by switching from active performance investing to low-cost indexing [funds].”
The futility of trying to beat the market is best described by Burton Milkier, economist and a director of the Vanguard Group for 28 years, who wrote in his book “A Random Walk Down Wall Street” that “a blindfolded monkey throwing darts at a newspaper’s financial page could select a portfolio that would do just as well as one carefully selected by experts.” Judging by the flow of dollars into ETFs, it is apparent that many investors agree with the philosophy, “If you can’t beat ’em, join ’em.”
Reasons to Invest in ETFs Over Index Mutual Funds
1. Investment Flexibility
ETFs come in a wide variety of categories, ranging from the broad U.S. market or global stock market, to a single asset category, such as individual commodities (gold, energy, agricultural) or industry sectors (small cap energy, metals and mining, homebuilders, alternative energy). Investors can even buy ETFs that represent the economy of a single country (such as Brazil, Germany, Canada, or Russia).
The availability of different (though related) ETF categories allows investors to “hedge” – using one investment to offset the risks of another. For example, an investor holding a position in Apple, Google, or other high tech stocks who doesn’t want to sell his position – but is worried about a short-term pull-back – could short-sell a technology sector ETF to reduce his or her risk. When the stock declines, the ETF will decline proportionately, offsetting the loss in the stock. As a consequence, though the stock loses value, the short sale becomes profitable, thereby hedging the risk of a market decline in the stock. According to ETFdb.com, ETFs can tame volatility, guard against inflation, and reduce foreign currency risks.
2. Transaction Flexibility
Since ETFs trade like stocks, shares can be purchased at any time. Limit and stop orders can be used to reduce the risk of intraday volatility. Short-selling is available, as well as purchasing on margin.
Unlike index mutual funds, ETFs allow an investor to trade in Chicago Board Options Exchange (CBOE) or NYSE options to buy or sell the ETF. According to Bloomberg Business, ETFs account for about 70% of all equity option volume, or $77 billion per day. Bloomberg attributes the volume to professional fund managers hedging their portfolios since the market can “absorb billion-dollar trades without missing a beat.”
3. Lower Expense Ratios
ETFs typically have lower costs of ownership than an index mutual fund. These costs include the administrative costs of managing the fund (commonly called the “expense ratio”), and include portfolio management, fund administration, daily fund accounting and pricing, shareholder services, 12b-1 fees, and other operating costs. A Morningstar studyfound that ETFs had lower expense ratios than index mutual funds in almost all categories, although the advantage was usually less than a quarter of 1%.
Some proponents of index mutual funds claim that the cost of transaction commissions and the size of the bid-ask spread (the difference between the price offered to buy a security and the price offered to sell a security) in an ETF offset the advantage of a lower expense ratio. A purchaser of index mutual funds is not subject to either cost.
4. Tax Advantages
Whenever a mutual fund owner redeems shares, the fund must sell securities to fund the redemption, triggering a capital gain or loss. Mutual fund holders – including index mutual fund holders – must pay taxes on dividends and capital gains for transactions occurring within the fund. By law, if a fund accrues capital gains, it must pay them out to shareholders at the end of each year. As a consequence, index mutual fund holders may incur a tax liability even when the fund has dropped in value during the year.
Due to the unique composition of ETFs, they are not required to sell any of their holdings to redeem shares, triggering a taxable event. Shares of an ETF are created and liquidated through transactions with an authorized participant (AP). An AP is a large institutional investor that has contracted with the ETF to provide baskets of the desired securities or cash to the ETF in return for the ETF shares, which are then kept or sold on a stock exchange.
As a consequence of the structure, an investor in ETFs will only pay capital gains taxesbased upon two factors:
- The cost of the initial purchase of the ETF and the proceeds of a sale when he or she divests his or her position
- The length of the holding period
5. Full Investment Exposure
ETF shares are bought and sold on the secondary market through a broker-dealer like any other stock, rather than through a mutual fund sponsor as for an index fund. As a consequence, the ETF assets are fully invested at all times. By contrast, a mutual fund sponsor must retain cash in order to fund share redemptions.
According to a study by Dr. Sergey Chernenko of Ohio State University and Dr. Adi Sunderam of Harvard University, the average cash-to-assets ratio in index mutual funds has increased over time, growing from 7% in 1997 to 9.5% in 2014. Even so, the authors of the study concluded that many fund managers did not retain enough cash to eliminate the risk of having to sell assets to fund redemptions.
While index funds and ETFs are required to price the net asset value (NAV) of their portfolios at the end of a trading day, the price at which ETF transactions occur is constantly changing, since prices are established in an auction process on the exchange. This means that the price of the ETF may vary from trade to trade or the NAV. On the other hand, purchasers and sellers of index mutual funds always get the NAV value established on the day of the transaction.
6. No Minimum Purchase
Many index mutual fund sponsors require a minimum purchase amount, ranging from $100 to $3,000 or more. According to The Motley Fool, some index mutual funds require as much as $50,000. A purchaser of ETF shares can buy one share at a time if desired, but must weigh the costs of commissions. If dollar-cost averaging is a desired strategy, an account with a no- or low-cost broker is essential.
Final Word
With their many advantages over traditional investment types, exchange traded funds have become increasingly popular since they were introduced in 1993. Their success has paralleled the widespread acceptance of Modern Portfolio Theory (MPT), which claims that individual security selection is not nearly as important as proper allocation into the most appropriate asset classes. In other words, balancing risk and reward through adequate diversification is the optimum investment strategy.
The utility of ETFs has also stimulated the growth of automated investment advisors, commonly called “robo-advisors“, enabling professional portfolio advice for investors with limited funds or those who prefer a DIY approach. Steve Lockshin of Convergent Wealth Advisors recognizes the benefits of ETFs and automated advice: “Computers are far better at executing the Nobel Prize-winning strategy of investment diversification and re-balancing than people are, and they’re much better at tax loss harvesting too.”
For those investors who lack the time, expertise, or interest in analyzing and monitoring individual stocks, ETFs are a compelling alternative, especially when executed with the advice of a low-cost brokerage firm and automated portfolio advice.
Are you buying ETFs? What has been your result?
The SPDR S&P 500 ETF Trust (SPY) fell $1.47 (-0.50%) in after-hours trading Monday. Year-to-date, SPY has gained 10.17%.
SPY currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 157 ETFs in the Large Cap Blend ETFs category.
This article is brought to you courtesy of Money Crashers.
