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Exchange Traded Funds At Prudent Asset Management, we primarily utilize Exchange Traded Funds (ETFs) for our client's portfolio. Exchange-traded funds are essentially passive index funds, similar to traditional index mutual funds that allow investors to purchase a portfolio of securities in a single transaction. The first exchange-traded fund was the S&P 500 index fund (nicknamed spiders because of their SPDR ticker symbol), which began trading on the American Stock Exchange in 1993. ETFs are the most practical vehicle for investing in a market both quickly and cheaply. What Are Exchange Traded Funds?
ETFs are very similar to index funds but there are some important differences and advantages to keep in mind. Unlike traditional index funds, ETF shares trade on an exchange and provide investors with a host of benefits ranging from increased liquidity to lower expense ratios to greater tax efficiencies.Advantage #1: Lower Expenses
The expenses for ETFs are dramatically lower than for those of other mutual funds. Annual expense ratios for ETFs range from .1% to .6%. The average annual expense for an actively managed fund? About 1.5% a year with some going as high as 2.5% a year! This difference may not sound like much but compounded over 15 years the results are dramatic.Compare the Vanguard 500 Index Fund, often cited as one of the lowest of the low-cost index funds, and the SPDR 500 Exchange Traded Fund. The Vanguard fund's expense ratio of 18 basis points (.18%) is significantly lower than the 100 to 150 + basis points (1.0%-1.5% +) often charged by actively managed mutual funds. But when compared to the SPDR's ETF's 11-basis-point (.11%) expense ratio, the Vanguard fund's expense ratio looks quite high. In fact the SPDR Exchange Traded Fund is 40% lower. Advantage #2: Tax Efficiency
Traditional open-end index fund managers have the added responsibility of meeting shareholder fund redemptions. Thus, traditional index fund managers must sell securities to generate cash for shareholder redemptions and in the process may incur taxable capital gains. On the other hand, ETF redemptions are for the underlying stocks in the index, and therefore do not lead to realized gains. Remember, individual investors buy and sell ETF shares on the exchange not within the funds themselves. Moreover, traditional index fund managers while meeting shareholder redemptions often avoid realizing gains by selling their highest cost basis stocks to meet redemptions. This results in the portfolio holding the lowest cost basis stocks, which could possibly generate larger capital gains in the future and a heavier tax liability. Conversely, when an ETF receives a redemption order, it ships out its lowest cost basis stock, leaving the highest cost basis stock in the fund for a possible lower future tax liability. In addition, when a change is made to the constituents of the index and turnover is required, the ETF should realize less in gains as a result.Advantage #3: Diversification
ETFs are well designed to create a diversified portfolio. There are hundreds of ETFs available, and they cover every major index (those issued by Dow Jones, S&P, Nasdaq) and sector of the equities market (large caps, small caps, growth, value). There are international ETFs, regional ETFs (Europe, Pacific Rim, emerging markets) and country-specific (Japan, Australia, U.K.) ETFs. Specialized ETFs cover specific industries (technology, biotech, energy) and market niches (REITs, gold).Advantage #4: Increased Liquidity
Exchange-traded funds are listed on an exchange and can be bought and sold throughout the day. Traditional mutual funds on the other hand are bought and sold based on the closing NAV (Net Asset Value - calculated based on the closing price of the fund's investments). ETFs intra-day trading allows investors to buy and sell ETF shares at a known price, unlike many traditional open-end funds that trade at the closing NAV price. |