Basics of ETFs

Exchange traded funds (ETFs) are very popular investment instruments.

The reason is that ETFs assist investors in achieving well-diversified portfolios on a cost-effective, efficient, and liquid basis. ETFs are available for almost every market, market niche, and asset class, thereby allowing small investors exposure to investments that they may not be able to access individually.

If you read this blog, you know that I like ETFs for individual investors.

Today, a few good ETF basics courtesy of Vanguard. 

ETF Popularity Continues to Grow

Vanguard offers a few useful points on ETFs that investors should keep in mind.

This is important as ETFs continue to increase in scope and complexity. Especially given the substantial growth in ETF assets under instrument over the last decade.

“At the end of 2001, ETFs held a total of $83 billion in assets. By early 2012, that figure had soared to nearly $1.2 trillion,” Mr. Dickson said, citing data from Simfund.

Not bad for 10 years. There has been a huge increase in ETFs over the last few years.

The relatively low cost, generally high liquidity, wide range of funds, and ability to easily diversify one’s portfolio are the prime drivers for increased investor demand.

The fact that active asset management does not typically outperform a passive approach is another key reason investors are simply trying to replicate benchmark returns with ETFs.

But Not All ETFs Are Purely Passive Index Funds

When people think of ETFs, normally the passively managed, traditional major index ETF pops up. To attract investor interest, many of these ETFs had colourful names, including: Spiders, Diamonds, Vipers, Cubes. But the ETFs themselves were plain vanilla index funds.

Over time, fund companies try to attract new investors with ETFs that were more exotic than just the name. From the linked Vanguard article:

While most ETFs follow an indexing strategy, some are actively managed, use borrowed money (leverage), or invest in gold or currencies.

Or other investment options. Besides actively managed, leveraged, and alternative asset ETFs, you will also find other ETF options such as inverse, life-cycle, and wraps.

If a fund company thinks investors will invest in some ETF strategy, a fund will be created.

But always consider a couple of points when assessing new ETFs.

Increased Complexity Equals Higher Costs

A good general rule is that the more complex the fund, the higher the ETF expense ratio.

I believe that investors should normally attempt to minimize their investment costs, so be very careful before paying higher fees for exotic ETFs. The return may not justify the extra cost.

Increased Complexity May Mean Higher Risk

Another good rule is that the more complex the ETF, often the higher the potential risk.

Yes, complexity can be used to reduce risk – especially if derivatives are utilized to offset risk – but many exotic ETFs enhance portfolio risk. Leveraged ETFs are one excellent example.

When you see a complex ETF, ask how the ETF structure impacts the risk-return relationship.

Myths About ETFs

Vanguard makes two good points concerning ETF myths.

Myth: ETFs are used only by speculators and frequent traders.

Myth: ETFs cause market volatility.

Yes, ETFs are used by speculators. But they are excellent vehicles for long-term investors. In fact, they may be the best investments for smaller investors building wealth over time.

And yes, ETFs sometimes get blamed for market volatility. However, it is the underlying economic, political, financial, etc., factors that impact market movements. So I think the blame is largely misplaced.

I will grant though that the amount of assets within ETFs and the easy/quick manner in which investors en masse can move in and out of entire markets may affect overall prices in the short run. But if you are investing for the long run, then short term volatility will give way to long term market trends. Trends that are based on the underlying data.

ETFs are excellent investments for long-term investors. However, as more fund companies chase investor capital, we will continue to see innovative, new funds created. When assessing any new investment, keep these basics in mind.

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