In the evolution of individual investors buying securities, we went from the era where all of these trades were placed through full service brokers, to the growth and prominence of the mutual fund, to self directed brokerage accounts where clients can place their own trades online.
Mutual funds offer the benefit of tracking a basket of various securities, although these cannot be traded directly and the orders for them have to be placed through a mutual fund dealer. Exchange traded funds, or ETFs, involve the marriage of mutual funds with online trading, where exchange traded funds or ETFs can be bought or sold directly through brokerages, where now you can trade baskets or stocks or other securities at will.
The fact that funds can now be traded on exchanges may not seem that meaningful, but there are some real benefits to this, and this makes them especially appealing to individuals who are directing their own portfolios or are at least playing an active role in its direction.
ETFs are a fairly new type of investment vehicle, first appearing in the early 1990s, and have grown ever since. Now, there is a wide assortment of things that you can buy ETFs with.
ETFs have traditionally tracked various indexes or other securities, much like an index mutual fund does, but without being limited to stocks and bonds. ETFs can be created for just about anything, and this has certainly added to the flexibility and usefulness of them over normal funds.
More and more investors are jumping on the ETF bandwagon with each passing year these days, from the smallest individual investor trading a few shares from home to large institutional investors who are now adding ETFs to their portfolios in spite of having the means to buy the individual components themselves.
Why ETFs Appeal to So Many
The fundamental basis for ETFs is pretty similar to mutual funds, which is to allow investors to own a variety of different securities without having to go to the trouble and expense of trading in each one individually.
Before these securities comprising of baskets of securities came into being, that’s exactly what one had to do, buy and sell each one separately. It came to pass that investors started looking at various securities indexes, groups of them, and sought to diversify their positions and also look to try to replicate the returns of these indexes.
In particular, many would see an index up a certain amount over a certain period of time, and then compare the returns they realized with their own strategies, and often saw that they fell short. Index funds, whose goal is to look to replicate the returns that these indexes saw by simply owning and holding everything in it, in the proportion that the index used.
Due to transactional and management costs, you can’t really replicate an index exactly, but at least this allowed you to do so prior to the deduction of these costs. Since index funds can be run fairly cheaply, more cheaply than actively managed funds, due to the lower cost of passive management, this can make a real difference in the returns.
Exchange traded funds take this to a new level, where due to the way that they are constructed, are even more efficient as far as costs go. This is due in large part from ETFs being put together and run by market makers, who profit from the trades even without added fees, where mutual funds buy and sell from these market makers and have to add their expenses on top of these trading costs.
So, in a sense, while ETFs don’t quite eliminate the middle man, if the middle man is the one that is structuring them, they are making money just from the existence and trading of the fund, so the fund’s actual expenses can be lower and more efficient.
The Fact that ETFs Are Traded on Exchanges is Actually a Pretty Big Deal
Exchange traded funds, being traded on exchanges, involve investors paying a spread, which might seem like a negative until you realize that all securities are traded this way, whether they are traded directly like ETFs are or indirectly like mutual funds are.
Being traded on exchanges in real time, combined with the demand that the more actively traded ETFs tend to have, end up yielding quite a bit more liquidity than mutual funds enjoy.
Mutual funds are famously illiquid compared to just about any other form of trading, due to the sheer size of the positions that mutual funds have to take. This is similar to any investor that trades in very large position sizes, as you can’t just move in and out of these positions at the bid or ask, because the current bid or ask will not have anywhere near the volume to fill your order.
These orders do move the market a fair bit and there are professional traders who make a good living just riding the waves of big orders, because they do move the price. So if a large order is being bought, this will drive the price up as it gets filled with lot sizes at the various levels up, and the average price paid will therefore be higher than the bid or ask at the time the trade was placed.
Unless you are placing a very large order for an ETF, you’ll be able to get filled at the price at the moment, and not suffer any real slippage. The net result is that your trades enjoy more liquidity and are therefore more price efficient than if you went with a mutual fund and they had to trade much bigger each time they placed a trade.
While both index mutual funds and index ETFs both add and subtract orders from the fund as they are bought and sold, it is the nature of ETFs being operated by those who fill these orders that represent the biggest advantage here. This allows ETFs to have much lower management fees, as low as 0.05%.
The other advantage of this is that you can enter and exit a position with an ETF at any point in time during the trading day, and even trade them intraday. This makes ETFs appealing to all varieties of investors, anywhere from the scalpers who may only be in a trade for a few minutes, right up to long term buy and hold investors, and everyone in between.
While one could trade mutual funds on a shorter term time frame, it’s harder to do as the price of mutual funds only settle once a day at the end of the trading day, so you don’t even know what price your order will be filled at.
So that in itself rules out a lot of strategies, and given that mutual funds actively seek to discourage trading their funds and prefer they be held longer term, they have ways to make this more difficult by charging additional fees to investors who trade too often by their standards.
Self-Directed Investment Is Really What Has Driven ETF Growth
What has really spurred the growth of exchange traded funds is the fact that so many individual investors direct their investments themselves these days. Many have traded individual stocks and may not have seen the results they have expected, and seek to look to diversify their holdings more, to an extent that they cannot achieve themselves due to this requiring a lot more capital than they have.
Given how much investment is placed online these days, with so many clients having access to online trading platforms provided by online brokers, the ability to buy funds this way has been certainly seen as very appealing by a lot of investors.
While things like online futures, options, and forex trading has spurred many, these only really appeal to short term traders. This is the case with derivatives by their very nature, as they are set up to only apply short term, and while there are some people who do trade forex in the longer term, most look to take advantage of short to medium term fluctuations, of a few minutes to perhaps a few months.
ETFs give traders access to just about all of these markets, where you can trade a wide variety of different assets, and can be traded in any time frame you wish, from seconds to decades if you want. More than anything else, this is what makes ETFs a one size fits all approach and is a major reason why ETFs have taken off in popularity so much lately.
So, even with the longer-term investors, ETFs require active participation by the investor, where they can take full ownership of their investments. While they now have no one else to blame but themselves should their investments fall short of their expectations, this does also foster the learning experience for the participants, and for many players, there is a great deal to learn indeed.
This can serve to whet the appetite of many investors and have them becoming even more active with their investments over time, as well as hopefully more competent with their management. Managing an individual portfolio is much easier to find success with than letting someone else do it with a conglomerate of money that limits what they can do to a pretty high degree.
Since most ETFs are passive investments, tracking baskets or indexes of securities, the components of the ETFs are not subject to investor preference, but the combination of ETFs an investor goes with as well as the timing of their holdings can make ETF investing anything but passive, and as far away from passive as you could imagine should one desire.
With all of this appeal, the growth in ETF volumes should continue to grow, as more and more investors take charge of their portfolios to various degrees and become more and more familiar with this method of investing.
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.
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