What to Know About Exchange-Traded Funds

By Judy Loy, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc.

The typical investor puts money into their retirement plan and sets an allocation of mutual funds to fit their time frame and risk tolerance. Mutual funds have historically been the investment of choice for plans and investors in general, but there is a (relatively) new kid on the block, Exchange-Traded Funds or ETFs, giving mutual funds a run for their money.

The first mutual fund was created in 1924, named the Massachusetts Investors Trust, which started with $50,000 under management and grew to $392,000 in one year.  We have come a long way as mutual funds now have $18.7 trillion in total net assets (2018 Investment Company Fact Book by the Investment Company Institute). With the move from defined benefit plans to defined contribution plans (401k, etc.), mutual funds have garnered $230 billion in net cash flows in the last 10 years.

Mutual funds are also called open-end investments because the share amount issued is open-ended.  Investors purchase shares directly from the open-end investment company rather than on the open market. Examples of open-end investment companies are names you are probably familiar with:   Vanguard, Fidelity, American Funds, etc. These fund families are open-end investment companies because they agree to buy or sell investors’ shares on demand. By contract, it is agreed that the companies will buy shares from their shareholders at NAV or Net Asset Value. Net Asset Value is based on the market values of the funds’ underlying securities and is calculated at the end of the business day (Normally, U.S. markets close at 4 p.m. EST every weekday). Mutual funds pool their investors’ money to buy a group of securities. Therefore, a mutual fund shareholder can get diversification with a minimal investment amount. Many funds permit monthly investments of $50.

Exchange-Traded Funds (ETFs) were first created in Canada in 1990, so they are considered a newer product by investment standards. ETFs have been available in the U.S. for 25 years and provide the ability to pool funds, like mutual funds, because they own a group of securities. Many people are investing in ETFs. As of 2017 year-end, U.S. ETFs held $3.4 trillion in total net assets with 1,832 funds available.

There are key differences between mutual funds and ETFs. First, ETFs trade throughout the day on the open market (on an exchange, thus the name). The fund family issuing the ETF does not agree to buy back shares or sell them directly. Thus, Exchange-Traded Funds are more susceptible to the supply and demands of the market. They can trade away from their NAV. As mentioned earlier, NAV is the value of all the underlying assets, so an ETF may trade away from its underlying market value due to more demand than supply (price is higher) or more supply than demand (price is lower than NAV). This won’t last long, but in a troubled market, it might make a difference to the price you get. That’s why it is important to buy ETFs that have enough volume to handle the amount of shares you will be trading. Because ETFs sometimes have low trading volume and are bought and sold on the open market, they can be sold short and more volatile than mutual funds.

Why would you buy ETFs? They are easily bought and sold on a moment’s notice during normal business hours through a broker, instead of finding out at the end of the business day what your proceeds are for your shares. ETFs tend to be cheaper than mutual funds. For example, Vanguard 500 Index Fund Investor Class (VFINX) tracks the S&P 500 and is a mutual fund. VFINX has an expense ratio of .14% and a minimum balance requirement of $3,000. The Vanguard 500 Index Fund ETF (VOO) has an expense ratio of .04% and no minimum requirement for purchase. To match the ETF expense ratio in a mutual fund, you would need to commit at least $10,000 to the Vanguard 500 Index Fund Admiral Class (VFIAX). These funds all track the S&P 500 and are managed by Vanguard, but their expenses, minimum investment and how they trade differ.

Typically, leveraged ETFs are for daily trading only and not for long-term investors. In fact, when investing in ETFs, watch out for those that use leverage. These are typically created for use by a short-term trader.  For example, the Direxion Daily S&P 500 3x Shares (SPXL) is designed to move three times the movement of the S&P 500 daily. However, it is not designed to be held long-term and may differ from the market movements over a longer time. Thus, it is always important when considering an investment to know the investment objectives of the fund.

To decide if mutual funds or ETFs make sense in your portfolio, consult with your trusted advisor. There are many funds of both kinds for investors and the right fit for one might not be for another.

Nothing contained in this article should be interpreted as a promise or guarantee of earnings or investment results nor a recommendation for the purchase or sale of any security or sector. Annuities are complicated products and each policy should be reviewed carefully with a fiduciary advisor.