Another sign of spring here in the Chicago area is the appearance of lines on the local youth soccer fields. All three of our kids played soccer and we still miss watching them play.
So what do ETFs and youth soccer have in common? From our experience as the parents of three travel soccer players, including one who was a ref for several years, very few parents understand the rules of the game which sadly too often leads to some really bad behavior on their part. From many of the questions that I get and from what I read many investors don’t understand ETFs all that well either. This post will attempt to highlight some of the basics of ETF investing for those readers who may be unclear or have a few questions.
(One example of some over the top soccer parents occurred when our now 23 year daughter was playing in a 9 year old game. Some parents from the other team came over to our side of the field and started a fight. My wife ended up as a witness in soccer court and two dads ended up being banned from any Illinois youth soccer game or practice for two years.)
What is an ETF?
According to the NASDAQ site:
“In the simplest terms, Exchange Traded Funds (ETFs) are funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index, but simply replicate its performance. They don’t try to beat the market, they try to be the market.
ETFs have been around since the early 1980s, but they’ve come into their own within the past 10 years.”
In simple terms ETFs are essentially mutual funds that trade on the stock exchanges much like shares of common stock such as Apple or IBM. They are bought and sold during the trading day just like stocks.
While it is true that the first ETFs were index tracking products, actively managed ETFs are coming into play with perhaps the most successful active ETF so far being the ETF version of PIMco’s Total Return bond fund (ticker BOND).
Advantages of ETFs
ETFs have several features that are advantageous to investors:
- Most ETFs are transparent as to their holdings.
- ETFs can be bought and sold during the trading day.
- Stop orders can be used to limit the downside movement of your ETFs.
- ETFs can also be sold short just like stocks.
- Many of the index ETFs carry low expense ratios and can be quite cheap to own.
- Due to their structure, many ETFs are quite tax-efficient.
- ETFs provide a low cost, straightforward way to invest in core market indexes.
Disadvantages of ETFs
- ETFs can be bought and sold just like stocks. In some cases this could cause investors to trade in and out of ETFs when perhaps they shouldn’t.
- The popularity of ETFs has caused ETF providers to introduce a proliferation of new ETFs, some are excellent, some not so much. Many new ETFs are based on untested indexes that have only been back-tested. Additionally there are a number of leveraged ETFs that multiply the movement of the underlying index by 2 or 3 times up or down. While there is nothing inherently wrong with these products they can easily be misused by investors who don’t fully understand them.
- Trading ETFs generally entails paying a transaction fee, though a number of providers have introduced commission-free ETFs in order to gain market share.
All ETFs are not created equal
Much of the growth in ETFs was fueled by basic index products such as the SPDR 500 (ticker SPY) which tracks the S&P 500 index. Vanguard, ishares, and the SPDRs all started with products that tracked core domestic and international stock and bond indexes. The popularity of ETFs grew in the wake of the financial crisis and ETF providers have been falling all over themselves to bring new ETFs to market.
Some of these new vehicles are good, but others track questionable indexes or benchmarks. These products are essentially made up in a lab, reminiscent of Gene Wilder, Terri Garr, and Marty Feldman in Young Frankenstein.
Free trades are good or are they?
Fidelity and Schwab most notably have offered platforms that allow commission-free ETF trades for their own branded ETFs and a select menu of other ETFs. This is fine as long as these are the ETFs that you want to own. Note I’ve found that several of the Schwab ETFs are very low cost and track core indexes so they can be good choices.
Additionally you can trade Vanguard’s ETFs commission-free if you trade in an account at Vanguard.
At the end of the day you should buy the ETFs that are best for your situation. This assessment should include the underlying ETF benchmark, the expense ratio, and the liquidity. If you can trade it commission-free so much the better.
Overall ETFs can be a great investment vehicle for both traders and long-term investors. As with any investment vehicle it is incumbent upon you to understand what you are buying and how it fits into your investment strategy.
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