The spectacular growth in exchange-traded funds (ETFs) over the past decade has spurred a new generation of budding investors to discover what is an ETF and exactly how these funds make investing less risky, low-cost, and accessible.
Learning more about ETFs makes sense, if only because they are everywhere in the world of investing. The global ETF industry rose from just $716 billion in assets in 2008 to a whopping $6.18 trillion in 2019, an incredible increase of 863%. In the same period, the number of stock market listed ETFs grew by 431%, from 1,617 to a total of 6,970, and the variety of ETFs continues to grow.
Today, ETFs can account for about a quarter of the daily volume in the U.S. stock market, and this volume can jump up to as much as 40% on some days, according to Bloomberg.
The credibility of ETFs has risen so much, reports Bloomberg, that even pension plans and insurers now use these funds as the low-cost core of their portfolios.
As more professional and individual investors embrace ETFs, a broader desire to understand how ETFs benefit the average investor has emerged.
In this article, we will answer all of your questions about ETFs as we consider:
- What is an ETF? A definition
- What is an ETF? The history of the exchange-traded fund
- 7 benefits of ETFs: Why ETFs became popular
- The future of ETFs
- How to get started investing with ETFs
Let’s begin with a definition.
1. What is an ETF? A definition
An exchange-traded fund (ETF) is a basket of assets such as stocks, bonds, and REITs that tracks the performance of an underlying index (more often than not), and trades on a stock exchange.
Using this definition, there are four essential features of an ETF:
- An ETF is a basket: A single ETF of an asset class (e.g., stock ETF) contains numerous assets that belong to that class.
Unlike individual stocks, where a single purchase means you have a stake in one company (one asset), with ETFs a single purchase gives you a stake in the many assets that constitute that basket.
For example, if you purchase the Vanguard S&P 500 ETF (VOO), you have a stake in all the companies that constitute the S&P 500 index.
- ETFs cover a variety of asset classes: The three major asset classes are stocks, bonds, and REITs. There are stock ETFs like Vanguard S&P 500 ETF (VOO), bond ETFs like Vanguard Total World Bond ETF (BNDW), and REIT ETFs like Vanguard Real Estate ETF (VNQ).
- ETFs often (but not always) track an underlying index’s performance: The goal of an ETF is to match the performance (returns) of an underlying index. For example, the Vanguard S&P 500 ETF attempts to approximate the performance of the S&P 500 index. Unlike mutual funds, ETFs track the market’s performance, vis-a-vis the underlying asset instead of attempting to beat the market.
- ETFs trade on the stock market: Investors trade ETFs on a stock exchange. Unlike index funds (that also track the performance of an underlying index) that are only priced at the end of the day, you can purchase ETFs at any time the market is open (throughout the day). In this way, they trade like individual stocks on the stock market.
2. What is an ETF? The history of the exchange-traded fund
How did ETFs come to achieve such astronomical growth during the 2010s?
As helpful as the definition of an ETF is, the question at hand (what is an ETF?) cannot be adequately answered without a brief history lesson.
The popularity of ETFs is largely linked to a growing trend for adopting the passive investing approach.
This story begins a few decades back. In the 1970s, investors realized that active management (a style of investing) did not fulfill its promise.
The active management approach was applied by managers of mutual funds in an attempt to outperform the market. They did this by studying and selecting the right type of assets in their portfolio to justify the costs of management.
Active managers charge individual investors a high price to cover overheads and other management expenses on the promise that they will outperform the market, thus justifying the high cost to hire them.
However, many active managers could hardly keep up with the market’s performance; even less outperform it.
The solution to this problem came in the form of a different approach, called passive investing.
From passive investing to ETFs
In 1976, John “Jack” C. Bogle, founder of Vanguard Group, created the first passively managed index fund that tracked the S&P 500.
Unlike the active funds, an index fund seeks to perform as well as its underlying index. Consequently, they are less expensive (less overhead cost and management expenses) and more tax efficient.
[Learn more about the difference between active and passive investment]
Active managers found an important use for this new type of fund. Since active managers try to outperform the market, they need means to measure the market’s performance. They do this through indexes.
For example, the S&P 500 index tracks the performance of 500 large-cap companies in the U.S. There is also the Dow Jones Industrial Average (DJIA), which tracks the performance of 30 large-cap companies in the U.S.
These indexes, initially created for the active managers, became a useful tool for the pioneers of passive investing. They had a standard measurement they could attain. All they had to do was create funds that mirror a particular index, hence the development of index funds, spearheaded by John Bogle at Vanguard.
Twenty years later, ETFs arrived on the stage. The first ETF, SPDR S&P 500 index (SPY), was created by State Street Global Insights in 1993. While they had similar features with index funds, ETFs offered more.
First, they offered more liquidity since they are traded like individual stocks on the stock exchanges. While you can only buy index funds at the close of the market, you can buy ETFs throughout the day.
Over time, ETFs have also shown more flexibility and innovation. But more on all that in a bit.
ETFs and the 2008 financial crisis
The 2008 recession saw the collapse of many investment banks in the U.S., which was led by Lehman Brothers.
The recession wiped trillions of dollars off the markets causing panic among investors. Institutions once believed to be unshakeable came down on their knees.
Consequently, many investors began to challenge the actively managed funds that charged high fees, incur high taxes, and yet failed to outperform the market. People began to see that they were taking more risk without a higher return to go with it.
This overexposure to risk wiped out large volumes of investments in the recession. Suddenly, even the average investor saw the folly of active investing, and this made people begin to care more about risk instead of an obsessive fascination with returns alone.
This is when a new trend began. The investment community started to abandon the actively managed funds that delivered less than they promised in favour of index funds and ETFs. They saw that these passively managed funds allowed them to minimize risk as they seek to passively track indexes and benchmarks rather than beat them.
The post-recession attitude confirmed Harry Markowitz’s view that the primary concern of the investor is to minimize risk.
Since then, the growth in ETFs has been astounding. Investors discovered an alternative strategy that would minimize their risk and mitigate losses when market volatility strikes.
By 2019, the ETF industry would be worth $6.18 trillion, with 6,970 ETFs being traded on the market.
3. Seven benefits of ETFs: Why ETFs became popular
ETFs did not become popular only because active managers were failing. Their rise can be associated with the fund’s inherent ability to offer a low-cost, diversified, flexible and innovative trading option to the average investor, be they novice or professional.
To understand what is an ETF, we must now look at the benefits of this popular fund.
1. Lower cost
Active management means that a portfolio manager must diligently pick specific stocks to invest in, rather than let the investments track a broad, diverse index.
For this reason, mutual funds typically charge more in fees than ETFs, mostly because of the additional costs spent on analysts, economic and industry research, all on top of management.
In the US, the average expense ratio, or administrative and operating expenses, of mutual funds was 0.78% in 2017, whereas it was only 0.21% for equity ETFs, according to the Investment Company Institute.
Expansion in the variety within the ETF industry has been nothing short of innovative. The first ETF came out in 1993, and now there are more than 6,000 ETFs.
ETFs now offer more niche-specific funds (robotics, technology), foreign market funds (emerging market funds, developed market funds), sustainability funds (ESG; ie, environmental, social, and governance-funds), factor-based funds (high-dividend yield funds, minimum volatility funds), and leveraged and inverse funds (short and bear ETFs).
This innovation is another reason why ETFs are growing faster than index funds.
3. Increased diversification
One of the results of such innovation is increased diversification. Using this unparalleled range of stock market exposure, investors can further diversify their risk by investing across disparate industries (pharma and finance, for example) and markets (developed and emerging). ESG funds can also help reduce the long-term risk of a portfolio.
4. Trading flexibility and liquidity
ETFs trade on the stock exchange throughout the day, thus offering investors more trading flexibility and liquidity. You don’t need to wait until the end of the day to buy ETFs.
ETFs are heavily traded throughout the day among many different parties. This makes them quite liquid, which means they can be traded quickly without changing the asset’s price and making it easier to rebalance a portfolio.
A Greenwich report shows that 90% of asset managers prefer bond ETFs to other sources primarily because of the liquidity they offer.
Index funds don’t have such flexibility and liquidity.
No one explains this point better than Mark Fitzgerald, Head of Product Specialism at Vanguard. Responding to the question “What finally took ETFs mainstream?” in an interview with Sarwa, he said:
“The beauty of an ETF is it’s democratic.
“If you or I want to buy an ETF product, we pay the same price as a sovereign wealth fund. There’s no other share class. There’s no hidden pricing. The cost is the cost. And so as institutions and professional managers have adopted more and more usage of ETFs, that’s created competition and demand.
“In turn, that’s brought down prices, which has been great for the end investor. This growth and adoption then created a ton of choice and price compression, so we can all benefit from that by buying this product at the same cost.”
Most ETFs provide a daily report, so you know exactly where your money is invested. Mutual funds are required only to disclose their portfolios every quarter.
This means you can see the securities that constitute your ETF at any point in time.
“There’s not a whole lot of manipulation that a fund manager can do when his picks are tied to an index. All in all, ETF investors are much less likely ever to get bamboozled than are investors in active mutual funds.”
7. Lower upfront payment
Mutual funds often require high initial investment minimums.
With ETFs, you can buy as little as one share — which means you don’t need a large balance to get started. You can even buy a fraction of a share of an ETF.
4. The future of ETFs
ETFs are a disruptive technology that has transformed the investment climate. But ETFs are not done with their story, not even close.
The mainstream adoption of ETFs is one of the crucial fuels propelling the rise of robo advisors.
A robo advisor helps investors automate their investments by creating a diversified portfolio of ETFs that reflect their risk tolerance. Robo advisors also provide the automated rebalancing of portfolios to keep up with the investor’s risk tolerance.
Robo advisors are also far more low-cost options than the average financial advisor or wealth manager. For example, Sarwa charges between 0.5% and 0.85% on your account balance, which is very low compared to the 2% to 3% financial advisors or wealth managers charge.
[Learn more about robo advisors here: How Can An Online Financial Planner Help Me]
Mark Fitzgerald at Vanguard also believes that ETFs will be a big part of ESG Investing in the future.
“I think the market is still trying to work out what that’s going to look like. There’s a lot of regulatory changes; we’ve got the Paris Accord. So I think there will be innovation there because the world has to address climate challenges,” says Fitzgerald.
He also expects us to see more fixed-income (ie, bond) ETFs.
“I think also we’ll see continued growth in the fixed income side because — in the end — the ETF story has been led by equities over the last 20 years.”
The Greenwich report quoted above echoes his sentiment. It shows that 60% of asset managers have increased their investment in bond ETFs, with allocation to bond ETFs now 18% of total fixed-income assets.
5. How to get started investing with ETFs
You now have a clear idea of what is an ETF and how it benefits investors.
ETFs can be bought through your broker like you buy stocks on the stock market.
To do this successfully, however, you will still need to research the thousands of ETFs available in the market and create a broadly diversified portfolio. You will also need to know how to achieve broad diversification with your ETFs choices.
Robo advisors have taken away the stress of this operation. Instead, with a robo advisor like Sarwa, you’ll receive guidance in determining your risk tolerance to construct a portfolio that matches your unique financial profile.
Sarwa uses the Modern Portfolio Theory to choose ETFs to minimize your risk and maximize your return given your risk appetite.
With Sarwa, it has never been easier to use ETFs to achieve broad diversification for long-term investment goals.
Below are some sample portfolios, structured according to various risk profiles.
Sample portfolio ratio designed to minimize risk:
Sample portfolio ratio for average risk:
Sample portfolio of higher risk tolerance:
- There are four main features of ETFs: It’s a basket of securities, it cuts across various asset classes, it mostly follows and tracks the performance of an index, and it is traded, like stocks, on the stock exchange market.
- ETFs arose as part of the transition from active investing to passive investing.
- After the 2008-2009 financial crisis, ETFs became popular as more people saw the folly of active investing.
- ETFs are low-cost, tax-efficient, democratic, innovative, flexible, liquid, and transparent. They also increase diversification.
- ETFs have been responsible for the growth of robo advisors. We also see more ESG and fixed-income ETFs. These trends will continue.