logo  
Sign in or Register

Already a member?

Sign in

Or sign in with your account on:

Not a member yet?

Register
    

Why Invest in ETFs?

By  +Follow September 1, 2014 10:00AM
Share:
Tickers Mentioned:

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.


Liked What You Read? Join Equities.com as a contributor and get eyeballs on your content FOR FREE!

Results for SPY
Jim McT
21 Oct 14 18:24:47
I've noticed quite a few stocks that took the elevator down,actually took the elevator back up! $SPY
♥ @MyOrgone ♥
21 Oct 14 18:24:43
Ditch $KO!! Make 100% a year with our 'Top 10 Hedge Fund' Artificial Intelligence - http://t.co/x7MDlPJXnp @CNBC $SPY
TheHealingBodyDigest
21 Oct 14 18:24:19
RT @philstockworld: The Levels We're Watching and the Positions We're Taking for the Week Ahead: $SPY $DIA $QQQ $IWM $AAPL -- http://t.co…
TheHealingBodyDigest
21 Oct 14 18:23:57
RT @philstockworld: What Lines We're Watching and How to Play them in our Short-Term Portfolio: $SPY $IBM $DIA $IWM $TNA #Hedging -- http:…
David Taylor
21 Oct 14 18:23:12
Yahoo surges on results. Bullish forecast on $YHOO around Alibaba IPO published 3 months ago: http://t.co/ZEHDd6MwYd $SPY
Don Right
21 Oct 14 18:23:04
Yahoo surges on results. Bullish forecast on $YHOO around Alibaba IPO published 3 months ago: http://t.co/TCi0O8nsDA $SPY
Gary Thomson
21 Oct 14 18:22:53
Yahoo surges on results. Bullish forecast on $YHOO around Alibaba IPO published 3 months ago: http://t.co/LddGHsldZM $SPY
Gary Thomson
21 Oct 14 18:22:43
Yahoo surges on results. Bullish forecast on $YHOO around Alibaba IPO published 3 months ago: http://t.co/4hHuYq7Ikz $SPY
MattBurns
21 Oct 14 18:22:31
Yahoo surges on results. Bullish forecast on $YHOO around Alibaba IPO published 3 months ago: http://t.co/RRcnf0xzpS $SPY
PortfolioWorkstation
21 Oct 14 18:21:00
RT @StockTwits: Here's a phenomenal chart. It shows every major v-bottom correction since 2013 -> http://t.co/NAtm06Q85I $SPY
Yemi Karunwi
21 Oct 14 18:20:31
Commented on StockTwits: $SPY $QQQ $IWM Like I mentioned yday short term outlook have turned bullish for stocks. ... http://t.co/Fj9R0hNfr9
Jeffrey
21 Oct 14 18:19:29
RT @philstockworld: The Levels We're Watching and the Positions We're Taking for the Week Ahead: $SPY $DIA $QQQ $IWM $AAPL -- http://t.co…
Jediphone
21 Oct 14 18:17:46
RT @StockTwits: Here's a phenomenal chart. It shows every major v-bottom correction since 2013 -> http://t.co/bbiX71jjFx $SPY
Jennifer
21 Oct 14 18:17:11
RT @philstockworld: The Levels We're Watching and the Positions We're Taking for the Week Ahead: $SPY $DIA $QQQ $IWM $AAPL -- http://t.co…
Jennifer
21 Oct 14 18:16:58
RT @philstockworld: What Lines We're Watching and How to Play them in our Short-Term Portfolio: $SPY $IBM $DIA $IWM $TNA #Hedging -- http:…
brian stu
21 Oct 14 18:15:30
I'm definitely not a commodities guy, but I think we have further downside in oil since it has not participated in $spy swing. JS #guess
artintelbot
21 Oct 14 18:15:15
Ditch $KO!!! Earn 100% a year with our 'Top 10 Hedge Fund' Artificial Intelligence - $SPY http://t.co/V5krQM4XpS
Dieselboss
21 Oct 14 18:14:04
RT @philstockworld: The Levels We're Watching and the Positions We're Taking for the Week Ahead: $SPY $DIA $QQQ $IWM $AAPL -- http://t.co…
Dieselboss
21 Oct 14 18:13:48
RT @philstockworld: What Lines We're Watching and How to Play them in our Short-Term Portfolio: $SPY $IBM $DIA $IWM $TNA #Hedging -- http:…
GBP Fractalerts
21 Oct 14 18:11:21
New $SPY alerts have recently been posted. Check them out now. http://t.co/06obSFSzuk
Fractal Forecasting
21 Oct 14 18:11:04
What is the $SPY going to do next? Get real time alerts and analysis at http://t.co/fRJvNGHFjy
Nathan Klint
21 Oct 14 18:10:17
RT @RyanDetrick: NAAIM going back to '06. Crazy to think, but equity exposure near '09 levels. http://t.co/thPYGHEiVD $SPY
Kyle Lusby
21 Oct 14 18:10:01
RT @philstockworld: The Levels We're Watching and the Positions We're Taking for the Week Ahead: $SPY $DIA $QQQ $IWM $AAPL -- http://t.co…
Samantha Lee
21 Oct 14 18:09:43
"@EuromaidanPress:#Canada fighter jets intercept #Russia military planes @CBCNews: http://t.co/gg3AcHhG16 http://t.co/C01oEsH7eC" $SPY $SPX
Barnabas K
21 Oct 14 18:09:39
Berkshire profit on IBM wiped out over earnings forecast $IBM, $SPY, $DIA http://t.co/yJF8aEHm92 via @SFGate
Kyle Lusby
21 Oct 14 18:09:19
RT @philstockworld: What Lines We're Watching and How to Play them in our Short-Term Portfolio: $SPY $IBM $DIA $IWM $TNA #Hedging -- http:…
Van Castle
21 Oct 14 18:07:13
RT @gtlackey: TP Daily: straight up into the MA Bands, good spot for a rest $SPY $QQQ $IWM http://t.co/xscbJYL5Uk
Buyavette.
21 Oct 14 18:05:33
RT @philstockworld: What Lines We're Watching and How to Play them in our Short-Term Portfolio: $SPY $IBM $DIA $IWM $TNA #Hedging -- http:…
Sheldon McIntyre
21 Oct 14 18:02:56
"@RyanDetrick: Incredibly, the $SPX hasn't had a single 2% up day in '14. Not unheard of ('04/'05), but rare. $SPY http://t.co/ezbZwpD9fi"
Alex Rodriguez
21 Oct 14 18:02:17
RT @philstockworld: The Levels We're Watching and the Positions We're Taking for the Week Ahead: $SPY $DIA $QQQ $IWM $AAPL -- http://t.co…
Me_Sean
21 Oct 14 18:02:09
Discretionary had a strong day relative to staples (+1.1%). One of the pairs we are paying close attention to $xly $xlp $dia $tlt $spy $QQQ
Alex Rodriguez
21 Oct 14 18:01:56
RT @philstockworld: What Lines We're Watching and How to Play them in our Short-Term Portfolio: $SPY $IBM $DIA $IWM $TNA #Hedging -- http:…
Alex Chalekian, CEP®
21 Oct 14 18:01:27
RT @Lake_Avenue: Lake Avenue Market Close Update: #DJIA +215.14 #NASDAQ +103.40 #SP500 +37.27 #stocks #economy #markets #wallstreet $…
Anna Cobb
21 Oct 14 18:00:20
RT @lancejepsen: Institutional Trader Buying Detected on the TICK $SPY $TICK http://t.co/44uuPene5g #StockTrading http://t.co/6gAasBxKdW
Me_Sean
21 Oct 14 18:00:10
Lower oil prices is a pos for Chile. 20% of their inflation is tied to oil/energy. Neg for Colombia 50% of index is hurt. $spy $xle $EEM
Ryan Detrick, CMT
21 Oct 14 17:59:51
Incredibly, the $SPX hasn't had a single 2% up day in '14. Not unheard of ('04/'05), but rare. $SPY http://t.co/0DNLqD2PzS
Patty Oppenheimer
21 Oct 14 17:59:32
RT @philstockworld: The Levels We're Watching and the Positions We're Taking for the Week Ahead: $SPY $DIA $QQQ $IWM $AAPL -- http://t.co…
Momobreakout
21 Oct 14 17:59:03
RT @RedDogT3: Here's a link to today's video recap and look ahead $spy $xle $oih $aapl $baba $twtr $fb $celg. $gild http://t.co/ltgLhYcWl7
1971 Capital
21 Oct 14 17:58:59
not bad....ATA Truck Tonnage Index up 3.7% Y/Y in Sept $IWM $SPY $QQQ http://t.co/Jr0GpiCJNr
Patty Oppenheimer
21 Oct 14 17:58:52
RT @philstockworld: What Lines We're Watching and How to Play them in our Short-Term Portfolio: $SPY $IBM $DIA $IWM $TNA #Hedging -- http:…
Mr Popular
21 Oct 14 17:57:20
I'm waiting for all of the market technicians to tweet out how these moves make sense??? $SPY $QQQ #Crickets
The Prodigy Group
21 Oct 14 17:57:15
RT @IncredibleTrade: $SPY $TWTR Big $ poll very bullish about the outlook for U.S. stocks thru the middle of 2015 http://t.co/T6lkXP0XfK ht…
Dale Brethauer
21 Oct 14 17:57:03
$SPY Trade Returns 92% - Full video Analysis. #trading #options #markets #traders http://t.co/ArPLZFpTPk
Amine Hambaba
21 Oct 14 17:55:25
@TommyThornton same for $SPY correct, I have not applied TD D wave for awhile
Terry Lyons
21 Oct 14 17:54:30
RT @AsianOptionGirl: Commented on StockTwits: we have R3 at $193.55, 21DMA at 193.65, next is $196.80 at 50DMA, then CRASH to $170. $SPY ht…
Van Castle
21 Oct 14 17:54:27
RT @sentimentrader: When the put/call ratio >1 and $SPY >+1.5% during a bull mkt. A week later, it added to gains only 4 times. http://t.…
Suzanne Kantra
21 Oct 14 17:54:23
RT @philstockworld: The Levels We're Watching and the Positions We're Taking for the Week Ahead: $SPY $DIA $QQQ $IWM $AAPL -- http://t.co…
Suzanne Kantra
21 Oct 14 17:54:01
RT @philstockworld: What Lines We're Watching and How to Play them in our Short-Term Portfolio: $SPY $IBM $DIA $IWM $TNA #Hedging -- http:…
G. Thomas Lackey Jr
21 Oct 14 17:53:55
TP 65min: all in strong RSI bull ranges, but getting hot quickly $QQQ $IWM $SPY http://t.co/z6wm4OhdvZ
Samantha Lee
21 Oct 14 17:53:28
hey @jimcramer thoughts on Carl Icahn being 'quite concerned' about the stock market? http://t.co/SnypnBdfto $SPY $SPX
				
				
By  +Follow September 1, 2014 10:00AM
Share:

Comments

 

blog comments powered by Disqus

About us

Equities.com is the most advanced interactive online social ecosystem for the financial industry, serving as a resource center and next-generation communication platform that connects self-directed investors with public issuers, market experts, and professional service providers and vendors. Registered members can leverage our exclusive proprietary research tools such as the Small-Cap Stars, which outperformed 90% of all small-cap mutual funds, and robust do-it-yourself E.V.A. research reports. The Equities.com Issuer Dashboard is the ideal tool to communicate and manage investor awareness campaigns to the investment community, as well as to access valuable resources to help your company grow.

Market Data powered by QuoteMedia.
Copyright © QuoteMedia. Data delayed 15 minutes unless otherwise indicated. Terms of Use.