Since perhaps the most famous Exchange Traded Fund was born in 1998, the investment vehicle has become a mainstay in many global investment portfolios. Despite their popularity, many investors simply don’t understand them and fail to embrace them. More recently, some ETFs have gained popularity by being actively managed by star portfolio managers or by tracking difficult to invest in Bitcoin. Let’s take a closer look at ETFs, go through a bit of history, discuss their benefits, and understand a bit of how they work.
If it quacks like a duck…
An Exchange Traded Fund, or ETF is an investment vehicle which is designed to track an individual or group of assets. That vehicle is traded during market hours on an exchange in the same fashion that one would trade individual stocks. The ETF share prices fluctuate based on the underlying value of its holdings. At this point you are probably thinking that ETFs are the same as the eternally popular Open-End Mutual Funds. Though they do have some similarities, there are vast differences, and we will cover some of those in this newsletter. One of the biggest differences is the fact that ETF investors can buy and sell shares on exchanges (as its name implies) throughout the market session. In the case of a Mutual Fund, investors can only purchase and redeem shares after the close at Net Asset Value (NAV), which is the actual value of all the securities in a mutual fund portfolio. So, indeed, one of the most popular benefits to holding ETFs is the ability to trade them freely. But there are many more.
Most ETFs can be purchased at low or no commissions through a broker dealer. In contrast, Mutual Funds can only be bought from and redeemed by the fund’s sponsor. Additionally, most mutual funds have load costs which are paid by the investor either up front (front load), or when the fund is redeemed (back load). Additionally, there are different share classes that carry different types of commission schedules. For example, Class C Mutual Fund Shares do not have front loads, but rather annual fees charged to holders. These are referred to as 12b-1 fees. Additionally, C-Shares typically charge a back load if redeemed in under a year. While there are many load-free funds available today, the majority of them still have some sort of fee attached to them. As ETFs have no direct commissions, they are considered a lower cost alternative to Mutual Funds. But there is more.
Read the fine print
Both Mutual Funds and ETFs charge management fees. However, ETFs typically charge significantly lower fees than mutual funds, which levy not only management fees, but also marketing costs, known collectively as an Expense Ratio. For example, the most popular actively managed mutual fund, Fidelity Magellan (FMAGX), has an expense ratio of 0.79%, which is slightly cheaper than average in its class. The largest actively managed ETF, the recently famous Ark Innovation ETF, charges a similar 0.75% expense ratio, though most investors turn to passively managed ETFs which carry significantly lower fees. More on that in a bit.
Nobody likes to pay taxes, but investors recognize that when they sell a profitable investment in a taxable account, they are going to have to pay a long or short-term capital gains tax. Many long term-focused investors are therefore not overly concerned with those taxes on a day to day basis, knowing that taxes will only be due when the investment is liquidated. Though that is true when holding individual equities or ETFs, it is generally not true with Mutual Funds. Mutual Funds contain the underlying investments, so when the manager rebalances or shares are redeemed, securities must be bought and sold. If those transactions yield net capital gains, they are passed on to investors, so a long-term Mutual Fund Investor can actually be taxed on capital gains without even liquidating. It gets really complicated, but ETF sponsors do not technically buy and sell underlying investments for rebalancing, creating, and redeeming shares. Those transactions are often completed as in-kind transactions between large financial institutions, known as Authorized Participants, and the ETF sponsor. The bottom line here is that there is typically no cash involved, which means no capital gains, which ultimately means no surprise tax liabilities. This offers ETF investors significant tax advantages over Mutual Fund Investors. It is important to note that everyone has a unique tax profile and that you should consult with a tax specialist when investing.
While there were several failed attempts at creating exchange traded funds in the late 1980’s the first, and longest living ETF was created in 1993. That ETF, affectionately known as Spiders or SPDRs (acronym for Standard and Poors Depositary Receipts), is a passive ETF designed to track the S&P500 Index and has the famous ticker symbol SPY, which many use to describe the index itself. Today, SPY has roughly $411 billion in assets and trades around 69 million shares per day. It wasn’t until 1998 that the popular Cubes or Q’s was borne to track the Nasdaq 100 Index. It started life with the ticker QQQQ, but eventually shed a Q to become the QQQ, that we know and love today. The Invesco QQQ Trust has some $198 billion in assets and trades around 38 million shares daily. In 2001, the Vanguard Group, historically known for its Mutual Funds, entered the market with the popular Total Stock Market ETF, ticker VTI, which tracks a portfolio of every publicly traded US Stock. VTI boasts around $279 billion in assets with 3.3 million shares changing hands, daily.
In 1998, State Street Global Advisors introduced the popular Sector Spiders which tracks the separate S&P500 sectors. This enabled investors to gain more focus on a specific sector of the market. Though we take this capability for granted today, the ability to tax and cost-effectively focus on diversified portfolios of stocks was ground-breaking.
The popular iShares line was launched by Barclays in 2000 and was ultimately sold to BlackRock in 2009. While iShares currently occupies 3 of the top 10 largest ETFs, it has the largest bond-based ETF which tracks an index of US Investment grade bonds. iShares Core US Aggregate Bond ETF, ticker AGG, has $89 billion in assets and trades around 5.1 million shares a day.
All of these popular funds mentioned heretofore have been passively managed. That means that the ETFs mirror the members of an underlying index, including the same allocation weights. For example, the SPY ETF tracks all 500 or so S&P500 Index members in the same weight as the index itself. As most of the work is done using computers, these passive funds typically come with lower fees and offer investors a very cost-effective way to gain exposure to an entire index. Imagine having to own all of the Stocks in the S&P500 and simultaneously keep the correct balance. You can simply purchase shares of SPY with low or no commission. SPY has an expense ratio of 0.095%… that’s less than 1/10th of 1%, or 9.5 basis points. In 2008, now defunct Bear Stearns launched the first actively managed fund. Actively managed funds track the performance of a managed portfolio in which a manager selects assets based on a strategy. There are indeed many types of ETFs, which serve many types of uses.
Flavors for all tastes
There are, indeed, many types of ETFs available today, all of which provide the benefits discussed so far. The primary differences of the fund are their focus. Here are a few different classes.
- Index ETFs. These are perhaps the most common. These are typically passive and duplicate the performance of well-known and some not-so-well known stock, bond, currency, or commodity indexes. Most recently, Factor ETFs are gaining some popularity.
- Actively Managed ETFs. This group, as its name implies, relies on a portfolio manager to select investments using methods designed to outperform passive, index-based ETFs. One type of actively manage ETFs that has gained popularity recently is referred to as a Factor ETF in which managers enhance allocation based on specific factors such as market capitalization or quantitative factors such as price momentum. The largest and possibly most famous actively managed ETF is Cathie Wood’s Ark Innovation ETF (ARKK) in which the manager attempts to beat the market by investing in disruptive innovation. ARKK has $21 billion in assets and trades around 5.4 million shares per day.
- Leveraged ETFs. These ETFs are typically based on an underlying index but offer a degree of leverage. For example, one can invest in a 2x leverages ETF which should move twice as much as the underlying index. For example, the Ultra S&P500 ETF by ProShares is designed to return 2 times the daily performance of the S&P500. **Hang on, don’t get too excited yet. These types of ETFs can be very risky and are not for everyone. Remember that you get 2 times the excitement when you are right but 2 times the pain when you are not.
- Inverse ETFs. This category is designed to go in the opposite direction of its underlying index. It is typically used to place bearish bets or to hedge a long position without having to short the market.
- Commodity ETFs. These funds invest in commodities such as energy, metals, and in agriculture. While these funds typically invest in physical products, for example bars of gold or silver, others invest in futures contracts. Futures contracts, while efficient, add a degree of risk as managers are required to roll from expired contracts into current ones which carries the risk of loss if contracts are in a state of contango, meaning the next contract is trading higher than the current one.
- Currency ETFs. These are designed to track the value of a currency or basket of currencies.
- Crypto ETFs. While not a traditional currency, Bitcoin has grown in popularity with investors over the past several years. With many managers now seeking to get clients exposure to the exciting crypto asset class, there are many challenges with direct ownership. On October 19th the first Bitcoin ETF began trading after a long-fought battle with the SEC. Rather than investing directly in Bitcoin, ProShares Bitcoin Strategy ETF, ticker BITO, invests in Bitcoin futures, as that was the only SEC-approved method for investing. Because the strategy requires the use of futures, the ETF has similar roll yield risks associated with some commodity ETFs. To learn more about the new Bitcoin ETF, please refer to my daily market note on the topic here: https://www.siebert.com/blog/2021/10/20/are-you-ready-for-bitcoin-etfs/.
To sum things up
Exchange traded funds offer investors a cost-effective method for gaining exposure to not only large indexes, but also to exciting active investment strategies. Because ETFs typically contain a basket of assets, they offer investors more diversity than owning only a few select assets. Purchasing and holding 1 ETF is far more cost-effective than owning all the underlying shares. Additionally, ETFs typically carry lower management fees than Mutual Funds and do not carry the same possibly negative tax implications. Because they are traded on exchanges, ETFs are highly liquid and orders can be entered similarly to stocks with stops, limits, etc. Many ETFs also have associated options, which offer investors yet another method to access this flexible and powerful investment tool.
Muriel Siebert & Co., Inc. is an affiliated broker/dealer of the public holding company, Siebert Financial Corporation, which also owns Siebert AdvisorNXT, Inc. Siebert AdvisorNXT, Inc. is a registered investments advisor (RIA) with the SEC and with state securities regulators. We may only transact business or render personal investment advice in states where we are registered, filed notice or otherwise excluded or exempted from registration requirements. Investment Advisor products are NOT insured by the FDIC, SIPC any federal government agency or Siebert’s parent company or affiliates.
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