Exchange traded funds (ETFs) are low-cost investment vehicles that provide exposure to broad portfolios or specific assets. I recently found an informative resource that answered questions I have had about ETFs. This video from ETF.com explains how the structure of ETFs provides benefits over traditional mutual funds, but also the added risks of investing in ETFs.
ETFs often maintain lower expense ratios than comparable mutual funds – yes, even broad-based index funds like Vanguard’s S&P 500 Index Fund*. But how can ETFs be competitive with index funds? And, while we’re thinking about the structure and processes of ETFs, how does an ETF grow in total value if its shares are traded on an exchange?
ETFs reduce the administrative costs of a fund by limiting interaction with shareholders. Instead of issuing shares to every individual who invests in their fund (individuals send money to mutual funds and mutual funds issue shares to individual investors), ETFs issue shares only to Authorized Participants that invest assets (such as blocks of shares in specific proportions) with the fund company. Authorized Participants are institutional investors that use market operations and the Creation/Redemption Mechanism to ensure the value ETF shares equal the value of their underlying assets.
Mutual Funds: Accept funds from and distributes shares to individual investors.
Exchange Traded Funds (ETFs): Only accepts blocks of assets from and distributes shares to Authorized Participants.
ETF shareholders benefit from lower fees because fund companies pass along cost savings related to lower administrative costs (ETFs do not need to transact with or maintain records for individual investors). Since Authorized Participants provide and redeem assets in kind, ETFs, unlike mutual funds, avoid realizing capital gains for continuing shareholders.
Unfortunate aspects of ETFs include standard trading costs for investors including bid-ask spreads and commissions on transactions. Mutual Funds, by contrast, may avoid commissions (when investors invest directly with the fund company) and always issue shares at Net Asset Value (NAV).
Simplified operations for fund companies plus low fees and diverse offerings for shareholders have incentivized the broad flow of funds into ETFs, but investors must be vigilant and fully understand any product in which they invest. ETF.com advises investment in highly liquid ETFs with narrow bid-ask spreads; to be aware of the impact of commissions; and avoid investing complicated leveraged products that are intended to be held for short periods.
I first learned of ETF.com from an interview of ETF.com’s CEO, Matt Hougan, by Consuelo Mack on Wealthtrack (an excellent educational source of investor information via interviews with influential investors).
*Technically, on the date I wrote this post, Vanguard.com reported the expense ratio for Admiral Shares of its S&P 500 index fund to equal the expense ratio (0.04%) for the comparable ETF. Investor shares can be obtained by an initial investment of $3,000 while the minimum required to obtain admiral shares is $10,000 – once your stake in any Vanguard fund crosses the minimum threshold to obtain Admiral Shares, Investor Shares may be converted to Admiral Shares.