The Benefits of ETFs

The function of any market is primarily a means of making transactions more efficient, bringing people together in order to transact business. Securities markets do that with those who wish to buy and sell securities, and the more that a market is successful at doing this, the more efficient it is and the better it serves its primary role.

The goal here is to allow those who wish to trade in certain securities to do so as easily and as efficiently as possible, and this benefits the market for the security by making its trading more liquid.

ETFs are generally set up to track baskets of securities of a common type, like components of a stock index for instance. If one wishes to diversify their stock holdings and seek to replicate the return of a certain index or basket of securities, one must acquire each of the components individually, or buy a fund that contains them.

While there is nothing particularly magical or even that noteworthy of a certain basket or index in itself, they do serve as proxies for the overall market of an asset class or sector, and the results are tracked closely, and people measure their success by how they do against these proxies.

If you own a basket of stocks for instance, you may track how you did against the market, and the market in this case will be a certain stock index that you use. In actual fact, the market would consist of a much larger group of holdings, all publicly traded stocks in a country or perhaps worldwide, but these indexes serve as a benchmark for the broader market.

If one seeks to replicate an index by buying an assortment of its components, this is going to be very inefficient. One may often not even have the means to do this, as the minimum lot size is often 100 shares, and depending on how much one has to invest, they might not even have enough to buy a single share of each company.

If one was able and willing to buy very small lots such as a few shares of everything, the commissions that one would pay would be prohibitive and would involve a high percentage of one’s capital.

With an ETF though, all one needs to do is buy shares of the ETF that tracks the index that they wish to track, and this easily achieves their desired result in just one transaction with a single commission paid.

This brings whatever level of diversification one seeks within easy reach, even with investors of very modest means. This also promotes more liquidity in markets because trades will be made that otherwise would not be possible if not for funds such as ETFs.

ETFs Are Also Very Flexible

ETFs not only offer investors easy and efficient access to a virtually unlimited amount of market diversity, they also offer a great deal of flexibility. While mutual funds also offer access to diverse funds, mutual funds are considerably less flexibility overall.

Trades for ETFs can be placed directly in the market by investors themselves, as opposed to their needing to be submitted by 2 PM with a mutual fund where the trade will be executed at the end of the trading day at a price to be determined.

This might be fine for an investor who only trades occasionally and also seeks to hold long term, and with these investors, being able to place trades in real time may not make any real difference to them.

For many investors though, this does matter, and especially those who do not expect to hold a fund for over a year, as trading funds within a year often will incur a penalty, as well as placing what are considered to be too frequent trades as defined by the mutual funds themselves, who basically wish you to trade as little as possible.

For those who do wish to trade or may trade their funds during shorter periods of time, the added flexibility of ETFs to be able to place your own trades from your brokerage account, and the fact that this can be done anytime without incurring any additional fees or penalties beyond the normal cost of the trade, makes ETFs considerably superior to mutual funds when it comes to the ability to place trades whenever one wishes.

The fact that one can also see what price one will pay for an ETF or will receive by closing their position can also be quite helpful. The shorter the duration of the hold or the expected hold of the ETF, the more important this becomes, since intraday prices will matter to the degree that the trade is being timed.

With the trades of the shortest duration, positions that are open and closed the same day, getting intraday pricing as well as being able to execute trades intraday is going to be essential. ETFs provide the means to execute these trades, where mutual funds of any sort do not.

Beyond that, if you’re holding positions for a few days on average, having your trades processed at the end of the day as mutual funds do is going to have you acting with quite a bit of uncertainty. As the time frame gets longer, this is going to have less and less of an effect on things, although in all cases it is preferable to some degree to have your trade orders executed live on an exchange.

ETFs Allow You to Take Short Positions

Unlike mutual funds, you can take short positions on ETFs as well as buy inverse ETFs which look to replicate the inverse of the performance of the underlying securities that are tracked.

Long term investors whose goal is to stay the course during whatever the market may bring may not care about such things, as they often do not even consider selling their positions and moving into cash to look to avoid the worst of market pullbacks, let alone look to capitalize on them.

ETFs allow you to either reduce or close your positions for periods of time as desired, as well as taking an inverse position to your long positions and look to profit from price reductions in a market.

There are many traders who take either side of a market, long or short, depending on the market conditions, and some who will play both sides of something the same day. Given the ebb and flow of security prices, one could even be in a position with a security either long or short at all times and go with where it is most likely to trend if one wished.

Whether or not one ever chooses to take advantage of the ability to profit from downturns in prices, ETFs do offer the ability to do this, and even have two different ways to do it.

You can use the traditional short selling that is used with stocks, where you borrow the shares from your brokers, sell them, and promise to buy them back to return them at a later date, hopefully at a lower price than you sold them short for.

You can also buy an inverse ETF which does not involve any short selling or borrowing of shares at all, as the fund itself is set up to go short with the components of it, and all you do is buy and sell as you wish.

Shorting an ETF does not require that one do so on an uptick as is the case with stocks. This can be a real advantage, especially if you are shorting a stock index or other basket of stocks that would normally be subject to this rule if you were shorting the stocks individually.

Of course, with the ability to trade a wide variety of different securities at the same time, with a single click you can be long or short an ETF instead of having to worry about having to exit and enter these trades one at a time, which takes time and may result in not getting in our out at the desired time or price.

ETFs Involve Lower Costs

Compared to buying and selling individual components, being able to buy or sell them in bulk can represent very significant saving as far as commissions and other trading costs. Each time you place a trade with a broker, you have to pay some sort of fee, and by doing it all with a single trade, this will allow for the minimum amount of trading fees to be paid.

When trading ETFs, you also only have to worry about a single spread, versus the multiple spreads involved in trading a number of securities. This does not mean that the overall spread will be cheaper with an ETF, and in some cases, with more thinly traded ETFs in particular, you may end up paying a little more than you would had you traded all the stocks individually, but when you factor in per trade charges this almost always has you coming out well ahead with the ETF.

ETFs do have management fees, apart from their trading spreads and transaction costs, as these are funds and it does cost at least some money to run funds, even passive ones. Someone has to process the transactions for the fund, keep records, and so on.

Compared to comparable mutual funds though, the management fees charged with ETFs come in considerably lower on average, and these savings might not seem like that much during a given year, but over time, these extra fees can really add up.

ETFs also offer some tax advantages over mutual funds. When you look at everything ETFs have to offer, it’s no wonder why more and more investors, even some very large ones, are becoming more and more interested in ETFs.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.