Investing Via ETFs

S. G. Lacey

With the disappearance of corporate pension plans and shrinking U.S. Government Social Security reserves, it’s becoming increasingly important for individuals to manage their own retirement savings. In addition, people are living longer today which necessitates having a larger nest egg in retirement.

One of the more recent and popular additions to an individual investors’ palette is the Exchange Traded Fund, or ETF.  This tool provides plenty of benefits over traditional mutual funds, which are the core investment vehicle in most corporate retirement plans (401k, 403b, etc.).

There’s no debating the trend of invested capital moving from mutual funds to ETFs and from active management to indexing (see the chart below).  In the future, younger investors will likely lean towards diversified, indexed equity exposure via ETFs, a dramatic shift from the baby boomer retirement holdings which are active mutual fund dominated.


The main benefits of ETFs are listed below with brief descriptions of each topic.

Improved tax efficiency = Due to SEC accounting rules, there are substantial tax benefits for those using ETFs in taxable accounts, most notably the lack of necessity to distribute capital gains each year like mutual funds are required to. These tax savings are less relevant in tax exempt/deferred retirement accounts, but ETFs can still be beneficial holdings in such savings vehicles for other reasons.

Low expense ratios = The expense ratio is the annual cost charged to own a security; currently the entire landscape of ETFs averages 0.50% (50 basis points) while mutual funds charge around 1.25%.  These costs are taken prior to any investment returns and are virtually invisible on a quarterly financial statement, but can be a huge drag on investment returns over the long term.

Real-time trading = One of the main differences between ETFs and mutual funds is that ETFs are continually traded when markets are open, while mutual funds are marked to market only once daily and settled at that price after hours.  Real time trading allows basic techniques like limit orders and short selling to be applied to ETFs, which is not the case with mutual funds.

Lower minimum investments = Mutual funds often have minimum investment values in the thousands of dollars plus charge further transaction and load fees.  In contrast, ETFs, combined with new online trading platforms, offer negligible trading cost with partial share purchasing options that allow for investment deposits of $100 or less.

Transparency of holdings = Multiple websites cover both ETFs and mutual funds, providing past performance, ratings, and other details.  In general, the holdings of ETFs are easier to determine, research, and monitor, since ETFs are being constantly traded whereas mutual funds are often only analyzed on a quarterly basis.

Breath of investment focus = If there’s an asset class you can think of, or even a minute subset, there’s likely an ETF designed to track it.  Increasingly, fund managers looking to bring new investment products to market are doing so through the ETF vehicle as opposed to a mutual fund.

When selecting between different ETFs there are several metrics to consider, each related to the potential ETF benefits previously discussed.

Net asset value (NAV) = This is essentially the value of the ETF as a whole; the sum total of all the stocks in its portfolio, or the price the market is willing to pay for those holdings.  In conjunction with the NAV, the bid/ask spread should be considered to assess how an ETF is trading relative to its underlying portfolio.

Fund size = The amount of money in a fund dictates how easily a position can be traded.  This is tied not only to the NAV described above, but also the total value relative to piers in the same asset class.  It’s important to avoid ETFs with both low total net assets, as well as fund providers with few ETF offerings since trading pools can easily dry up.  Looking at the 90-day average trading volume relative to large, commonly held ETFs is a good way to get a sense for a security’s liquidity.

Dividend yield = Like any stock or bond investment, returns can be generated from both price appreciation, a change in NAV, and any distributions from the ETF as a result of dividend payouts.  Trailing 12-month distributions should not be an investor’s sole focus for owning an ETF, but can be a valuable income stream while waiting for price appreciation.

Alpha and beta = These Greek terms provide guidance of the performance of an ETF relative to its selected benchmark.  Alpha quantifies the outperformance of a fund relative to its benchmark, with a higher value potentially denoting better manager skill.  In contrast, beta offers a quick way to determine the volatility and risk relative to its stated goal and piers, with a value of 1 denoting perfect correlation.  Tracking error is another commonly stated metric that can be used to examine the ability of an ETF to achieve follow the benchmark over time.

The screen shot below from Fidelity Investments shows many of these values for VTI, a popular U.S. total stock market index ETF.


Essentially, in today’s ETF landscape, an investor can deploy any desired amount of capital instantly online in nearly any specific global market with very low fees.  ETFs offer most of the transaction cost and speed advantages of owning individual stocks, while providing the strategy and diversification benefits of mutual funds.

ETF’s, like any investment, are not without their risks and drawbacks.  As a relatively new investment vehicle, the track record for many of these newer ETFs is short, and often only includes the recent bull market cycle, especially for those in the U.S. Equities space.  Performance for ETFs is documented daily, making graphical comparison of funds straightforward for any desired timeline.  However, it’s critical to look at other factors besides past performance before making an ETF investment purchase.

Also, it’s important to note that most ETFs are passively managed portfolios, simply tracking vehicles to a specific benchmark with no active management component.  There are an increasing number of numerical analysis, factor-based, and other long-short strategies in the ETF space; this is the topic for another post.

Lastly, with the wide range of ETF options and the ease of trading via the internet, there can be a tendency to transact excessively or make emotional investment decisions.  Having a clear investment plan and disciplined approach helps to ensure that ETF purchases are thoughtfully executed as part of an investor’s entire portfolio.

Below are a few useful online links which allow for simple and independent ETF research for those who are interested.  In subsequent months, I’ll focus on a core portfolio asset class segment and explore the various ETF options in that space.  The goal of this column is to simplify investing, using fundamental terms and concepts, while still being accurate and comprehensive; don’t hesitate to reach out ( if you have any additional questions or thoughts.

Invest wisely and don’t forget the power of automatic investment and compounding growth over time. = Ranking for ETFs by category, wide ranging and frequently updated. = ETF fund screener based on many of the metrics discussed above. = ETF overview podcast with lots of useful insight and plenty of ticker name drops.


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