If you follow and invest in the financial markets, there’s a good chance you’re familiar with ETFs. An ETF, or Exchange Traded Fund, is an investment vehicle that has become a popular way for investors to access the markets and specific asset classes. ETFs offer many benefits to investors; this article will cover some of the key reasons for the surge in assets targeted to these instruments over the past dozen years.
To understand ETFs, it helps to review their similarities and differences with mutual funds. Mutual funds are essentially companies that pool investors’ money to buy securities in different asset classes like stocks, bonds and real estate. The earliest mutual fund in the U.S. dates back to 1924. But these vehicles truly came into their own during the last half of the 20th century. A mutual fund enables investors to pool their investments, hiring professional money managers to invest their assets and access opportunities they might not have on their own.
Access to a wide array of investment strategies
You can think of an ETF as an evolution of the mutual fund. ETFs may invest in the same types of securities as mutual funds but with some small advantages. Typically, mutual funds are actively managed. Portfolio managers choose specific stocks, bonds, or other investments for what they believe are compelling opportunities, trading in and out of these vehicles. In contrast, many of the popular ETFs are passively managed: They’re benchmarked to a market index and their purpose is to replicate the returns of that specific market index.
This might be something broad and widely known like the S&P 500, or it could be something a little more exotic like an Emerging Markets small capitalization stock index. As more and more ETFs are launched, investors can utilize a wide array of strategies and asset classes, and achieve broad diversification.
Lower operating costs, lower entry points
Due to nuances in how ETFs are constructed and operated, they normally offer lower operating costs than comparable mutual funds with the same strategy. This allows investors simply looking for market exposure to access it at low cost by utilizing ETFs. For example, the iShares Core S&P 500 ETF had an expense ratio of 0.03% when this article was written. That’s essentially close to zero cost for an investor to buy and hold shares of a fund that replicates the returns of the S&P 500 Index. And it can be purchased without any investment minimums.
Unlike a mutual fund, which may have minimum investment requirements or sales charges, an ETF can be purchased at a smaller initial amount – and typically with nominal to zero commissions. Some brokerage platforms are experimenting with fractional share trading, which would remove one of the last hurdles for investors with limited investable resources. A high per-share cost for an ETF might be an issue if one share of an ETF were $454, for example. Fractional share trading allows investors to purchase fractions of ETF shares in dollars. Thus, you could buy $50 worth – a fractional share – of one ETF.
Many brokerage platforms like Fidelity and Schwab have reduced trading commissions to $0 for many popular ETFs and stocks within the past few years. This has helped make investing in the markets more affordable. Many leading ETFs also allow non-professional investors to participate in the market at operating costs that were available previously only to larger institutional investors, so the barriers to entry have been lowered dramatically.
Greater tax efficiencies
Separate from the cost benefits, ETFs generally offer more tax efficiency for investors holding taxable accounts. A pooled investment like a mutual fund is required by law to distribute the capital gains it incurs each year from sales of the fund’s holdings. These capital gains can sometimes be an unwelcome surprise.
ETFs offer the same type of market exposure but aren’t required to pass through capital gains distributions to the shareholder. That’s because ETF shares are created and redeemed differently. An ETF will still pass through income to the shareholder, so they are not tax-free and selling ETF shares at a gain is still a taxable event.
Easier to track throughout the trading day
Finally, one additional benefit of ETFs is that their price changes intraday just like a stock. If the index an ETF tracks is up throughout the trading day, the ETF price will track it to the upside, or conversely, track it down if the market is down. In contrast, mutual funds trade at one single price per day (the net asset value) for purchases and sales. Some active traders who follow trends or market signals can use this to their advantage, but this is a strategy that should be used with caution.
At Halbert Hargrove we utilize ETFs strategically in our portfolio construction to increase tax efficiency when possible and manage portfolio expenses. If you have questions about how ETFs can fit into your portfolio or how we can help with you, please contact us at 800-435-3505 or firstname.lastname@example.org.
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you seek the advice of a qualified attorney and accountant.
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