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Why Invest in ETFs?

By  +Follow December 26, 2014 7:00AM
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Once one is familiar with what exactly an ETF really is, it’s time to start digging a little deeper. The question of “why” becomes more relevant. Because it’s your money that’s at stake, and before your retirement or child’s college education gets put on the line, it’s probably worth understanding why people may or may not agree with your strategy in regards to using ETFs vs. mutual funds.

After all, the stock market was around for decades before anyone made an instrument like this widely available, despite the fact that the core principles guiding their creation are really pretty simple. How, then, do we go from no ETFs to over a thousand in a matter of 25 years?

The question is actually an interesting one, and has been a source of considerable debate among stock-pickers and economists alike. Can you really beat the market? Or do we all just need to accept that it’s so wildly unpredictable it can’t be tamed?

Here’s a look at some of the core concepts that have been driving people to shift towards ETFs and away from mutual funds.

Passive vs. Active Management

At the core of ETFs is the idea that “passive management” of a fund has certain advantages that can’t be matched by “active management.” Fund managers are “active” because they carefully pick stocks, but ETFs are “passive” because they are designed to replicate a particular market, rather than outperform it.

It’s an idea that’s rooted to some degree in the efficient-market hypothesis that recently won Eugene Farma a Nobel Prize for economics. The Efficient-market hypothesis postulates that the market is “informationally efficient,” which is to say that all the information relevant to a stock’s price is processed almost instantaneously, making it impossible to beat the market without assuming risk.

The idea has fallen out of fashion to some degree after the bursting of the housing bubble, but it’s hardly irrelevant. Whether completely true or not, the core concept continues to have value. Basically, it’s next to impossible to consistently pick the right stocks over time.

Even the great Peter Lynch noted that a 60 percent success rate made one a success, and, to those believing in efficient-market hypothesis, legendary investors like Warren Buffet or Benjamin Graham who maintained success over lengthy periods of time are the exceptions that prove the rule.

Like most economic theories (or just theories in general), efficient-market hypothesis doesn’t have to be an either/or proposition, no matter how much some academics may insist on viewing it that way. Even if you believe that a smart manager can beat the market by assessing risk better than others, and that the market isn’t perfectly efficient, you can still most likely admit that the persistent failure of the majority of fund managers to beat the S&P 500 would indicate that there’s at least some validity to the theory.

Expense Ratios

Of course, one might wonder: why not go with active management? With passive management, you can guarantee that you won’t beat the market. At least active management gives you a shot, so why not?

The answer would be that active management comes at a price. The companies that manage mutual funds employ armies of analysts, do thousands of hours of research, and have top-tier stock pickers who don’t come cheap. All of that costs money, and to pay for it the companies charge an “expense ratio.”

An expense ratio is usually expressed as a percentage and it’s what these companies charge in exchange for managing the fund. It’s what percent of the total value of your investment the company takes annually. So, if you invest $10,000 in John Q. Mutual Fund which has an expense ratio of 1 percent, and said fund gains 10 percent over the course of the year, your investment is now worth $11,000, so the manager of the mutual fund takes $110, leaving you with $10,890.

ETF Expense Ratios

Now, ETFs also have expense ratios. Even passively-managed funds require some maintenance, namely crunching the numbers and determining how much of which stocks to buy to maintain a portfolio that will match the returns of its target index.

However, this is ultimately a lot easier than actually researching and picking stocks and, as such, expense ratios for ETFs are consistently much lower than for most mutual funds. Mutual funds often feature expense ratios of 1 to 3 percent, while ETFs typically fall between 0.1 and 1 percent (the SPDR S&P 500 Index ETF (SPY) has an expense ratio of just 0.09 percent).

This discount may seem fairly small, but for a careful investor, it makes ETFs an opportunity to potentially save thousands of dollars a year, depending on the size of one’s investment. And, given that many mutual funds fail to beat the return of their comparable index, the question becomes clear: why pay extra for active management when, more often than not, it doesn’t produce any discernable advantage in returns?

There are, of course, still plenty of reasons to invest in mutual funds. They offer a variety of advantages that, depending on one’s investment situation, could be important. But that doesn’t change the fact that ETFs are cheaper to own and get similar or better returns in the majority of cases.

An ETF: A Mutual Fund that Trades Like a Stock

Of course, anyone familiar with index funds is scratching their head right about now. Since the 1970s, there have been mutual funds that track a specific index much like ETFs do, making the difference between ETFs and mutual funds one that can't be immediately explained away with a simple breakdown of passive management.

As such, another key distinction for ETFs (and one that is arguably more relevant in understanding what they really are) is that they trade throughout the day just like a stock would. This differs from many mutual funds that set their Net Asset Value (NAV) each day and trade at that price over the course of the day.

This is because ETFs are managed in a way that allows for one to liquidate shares of the ETF in exchange for its underlying assets. This serves to ensure that the value of the ETF matches the value of the stocks it represents by creating an arbitrage opportunity any time the ETF trades at a value that’s different from its underlying assets.

Namely, if the price of a share of SPY gets to the point where it’s lower than the basket of 500 stocks that comprised it, one could buy it, cash it in for the stocks involved, and then sell them for a profit.

And, if investor enthusiasm pushes the price of SPY above its asset value, one can also purchase shares of the ETF in kind. So you would buy up the necessary stock components and trade them in to SPDR for shares in SPY, which you could then sell for a profit. On the whole, this ensures that ETFs will continue to trade at or extremely close to their asset value on a consistent basis.

And the flexibility ETFs offer over mutual funds, with traders able to buy and sell them at different prices throughout the day, is another advantage that makes them an attractive investment vehicle to many. So much so that there are now many ETFs that don’t track a specific index, and even some that are actively-managed. While this may run contrary to the passive management concept, it speaks to the dexterity of the structure as it outgrows its original purpose.

Ultimately, even when buying an index fund that benefits from passive management like most ETFs, the flexibility and market regulation of the fund's value against its underlying assets built into the ETF structure can provide certain advantages. What's more, an actively-managed ETF still offers these benefits when compared to actively-managed mutual funds.

Using ETFs to Create Your Ideal Portfolio

Whether you’re an adherent to the efficient-market hypothesis or utterly convinced that you can pick the right stocks to beat the best, it’s likely that there’s a place in your portfolio for ETFs. With over 1,200 to choose from, the options to make plays on the future of many different markets make ETFs an attractive tool for any investor.


DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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Results for SPY
8 Oct 15 23:23:32
http://t.co/etBO89NR9a <-- Let me tell you a story about how knowledge is power in trading..$UWTI $SPY $VIX $XLE $XLP $OIL
Cedex F
8 Oct 15 23:21:37
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8 Oct 15 23:19:04
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das Bild
8 Oct 15 23:15:24
RT @WarriorNewsFeed: Most IMPORTANT steps to #DayTrading! #Stocks $SPY http://t.co/JDsEG4KQiY
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8 Oct 15 23:13:54
A/D $SPY is mucho strong http://t.co/jQTc61eNXs
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8 Oct 15 23:13:35
#FED #Jan29 #2016shift #rates #Yellen $FED $VIX $SPY #MarketCrash There is safety in numbers as #NASA (cont) http://t.co/kYlDd7zo4g
8 Oct 15 23:13:34
RT @LVX131: The #FED will act on #rates on #Jan29 #2016shift #Yellen $FED $VIX $SPY M&amp;A #Leadership #RedOctober #MarketCrash …
Call Me Baloo
8 Oct 15 23:13:23
$SPY short term indicators mucho overbought but they show no signs of turning down http://t.co/4lkzh4wRRm
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8 Oct 15 23:02:55
RT @KymLang: $SPY Weekly Gartley fits well here https://t.co/S78ha4C8zg via http://t.co/xwjHFVSbOf
Kym L
8 Oct 15 23:02:10
$SPY Weekly Gartley fits well here https://t.co/S78ha4C8zg via http://t.co/xwjHFVSbOf
Warrior Trading News
8 Oct 15 23:02:08
Most IMPORTANT steps to #DayTrading! #Stocks $SPY http://t.co/JDsEG4KQiY
8 Oct 15 23:01:31
#FED #Jan29 #2016shift #rates #Yellen $FED $VIX $SPY #MarketCrash There is safety in numbers as #NASA (cont) http://t.co/LTfqat9Duz
8 Oct 15 22:55:04
@kshahi as u see here on $SPY, V good break above of 50d (quite bullish) http://t.co/nLTINUMx33
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8 Oct 15 22:54:47
RT @seeitmarket: 6 Trading Myths Revealed - http://t.co/orAimUgKh3 by @RyanDetrick $SPY $DJIA $STUDY http://t.co/y71UzQxZmp
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RT @JLyonsFundMgmt: (Post) VIX Trips From 37 to 20 Have Been All-Or-Nothing For Stocks - via @YahooFinance $VIX $SPY http://t.co/IGO7OlXOAa
GLD Fractalerts
8 Oct 15 22:54:36
"Confidently trade $SPY http://t.co/qIg7Qw1h8M"
dxdp ~ nh
8 Oct 15 22:52:08
RT @HumbleStudent: Bingo! We have a extremely rare buy signal! $SPX $SPY http://t.co/k9QV7ux3OS http://t.co/s2xVtCGi0C
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8 Oct 15 22:51:01
Bingo! We have a extremely rare buy signal! $SPX $SPY http://t.co/k9QV7ux3OS http://t.co/s2xVtCGi0C
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8 Oct 15 22:45:14
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8 Oct 15 22:44:58
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8 Oct 15 22:44:32
RT @MT__Bigsky: $SPY $ES_F relevant http://t.co/ikcDO38wGD
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8 Oct 15 22:44:09
RT @Sandro_power: $SPY many bears thought this was a bull trap I guess they did not read my posted sept 30 chart pla http://t.co/b0gVeZ0XBJ
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8 Oct 15 22:42:57
how a market reacts to a very large buyer/seller better info than the actual trade... $SPY $TWTR
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8 Oct 15 22:41:32
S&P futures down 9 OR alternatively 127 above where i asked u to chill the f**k out... $ES_F $SPY
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i finally stopped following experienced trader on $TWTR who has been talking about shorting $SPY for last $10 once it gets to 204...
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8 Oct 15 22:13:34
RT @MT__Bigsky: $SPY $ES_F relevant http://t.co/ikcDO38wGD
8 Oct 15 22:12:08
seen plenty of 2011 fractals, here is a 2008 one. Short entry target 2040 $SPY $ES_F $SPX http://t.co/kcZG5jfQSz
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8 Oct 15 22:11:00
$SPY $ES_F relevant http://t.co/ikcDO38wGD
Peter Korkala
8 Oct 15 22:10:53
RT @seeitmarket: Will Best Start To October Since 1938 Propel Stocks Higher? http://t.co/cIT6tw2LTo by @RyanDetrick $SPY $STUDY http://t.co…
8 Oct 15 22:10:30
$ES_F short 2009 $SPY
Gavin Scott
8 Oct 15 22:09:02
Bullish on $SBUX & $UAL too, however I'm still bearish the market and I'm looking for a spike in $VIX ; $SPY $XIV $UVXY $DIA $QQQ $LABD
Michael Sanzo
8 Oct 15 22:01:34
@JustinPulitzer are you in the BTDs camp for the $SPY now?
R J Sullivan IV
8 Oct 15 22:00:40
$SPY $ES_F I would say Bulls have memories like fish but I don't want to insult the fish
By  +Follow December 26, 2014 7:00AM



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