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What are ETFs why should I care?

| January 22, 2020
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ETFs, or exchange traded funds have been gaining popularity steadily over the past decade and for good reason.  These funds are similar to mutual funds as they are diversified baskets of stocks however the major difference is that ETFs are usually unmanaged or passively managed while mutual funds are actively managed.  Mutual funds are only priced at the end of the day and ETFs trade throughout the day.  The added ability to trade throughout a day makes it easier to get better entry and exit into positions and also the certainty of price when your trade is executed.  ETFs are generally the best way to exposure to a certain sector you might  want.

Passive vs. active

Passive investing has seen a dramatic increase vs active investing but it is important to remember there are pros and cons to each.  With actively managed mutual funds you often pay for the expertise of management with a fee that can range from .5-1% and higher in some cases if you are not using institutional share classes.  With ETFs the fees can be as low as .05% and as high as .5%.  The key is determining when it makes sense to be active and where it makes sense to save on fees and be passive.  If you just own the index you will own some good companies and some bad companies and you will never be able to outperform the benchmark, but you won’t underperform it either. 

Historically passive investing does the best when the overall market is rising and active managers tend to perform best when the market goes sideways or down.  With the massive amount of assets currently in passive funds there is a concern that people could really get hit hard should the market start   underperforming.  There are many younger investors who automatically have been contributing strictly to passive investments throughout this bull market but they lack the experience that comes from more unfavorable market conditions.  Actively managed funds are typically much better at downside protection.

A new area that has been garnering more attention are actively managed ETFs, and most of these are rules based etfs.  What this means is that the basket of stocks is dynamic and can change at some regular interval when certain conditions are met.  I am a big fan of these.  Even the most experienced mutual fund managers have bad years from time to time and any human being will be subject to emotional decision making at some point.  The rules based funds generally make their changes based on quantitative factors such as price/earnings ratio, price to sales ratio, cash flow, etc. so the human element is completely removed.  Some of these rules can be an excellent way to identify undervalued stocks and sectors and may have the potential to outperform the market with less risk.

 

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  All performance referenced is historical and is no guarantee of future results.

An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program.  An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.

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