Why You Should Own Exchange Traded Funds
Exchange Traded Funds are powerful investment vehicles that enable average and inexperienced investors to maximize their return on investment.
Sep 30, 2022
This is an essay I wrote while attending Graceland University.
There are countless investment vehicles investors can use to grow their portfolios. Some investment tools are notable for diversification. Other investments are attractive for their low fees. Imagine an investment tool that maximizes control and diversification, minimizes fees, and requires minimal effort. That’s an Exchange Traded Fund. ETFs are collections of securities that can be traded like stocks. They are backed by pools of assets that are selected to track industries or indexes (Kosev 51). When evaluating ETFs compared to other investment vehicles based on return, risk, and personal management effort, ETFs generally have average return, low risk, and low effort. Exchange Traded Funds are powerful investment vehicles that enable average and inexperienced investors to maximize their return on investment.
The desire for index tracking tools started to increase as more investors realized that buying an index could outperform many other investment strategies. The first ETF was made as an index tracking tool, it went public to trade on January 1, 1993. This was the SPDR S&P 500 ETF ($SPY). $SPY was designed to simply track the S&P 500. This was and still is the main purpose of ETFs. Right now, $SPY is the most widely held fund in the world with total assets worth more than $181 billion and average trading volumes reaching over 120 million per day (TD Ameritrade). Now there are ETFs that track most any index one can think of including stocks, REITs, bonds, and commodities (Simpson). ETFs have proven to be successful trackers of indexes and industries, making them effective investment tools.
ETFs are a great tool to utilize in a retirement portfolio. It is important to start saving for retirement early in life. The power of compound interest is astounding when starting to make a retirement plan. Figure 1 demonstrates the power of compound interest, the difference is demonstrated by Susan and Bill. Susan invests $100,000 less than Bill, but invests from ages 25-35 instead of from 35-65. Susan ends up with $57,000 more at age 65 simply because she invested early. This is the power of compound interest. Many people do not know where to start investing and end up putting it off until later in life, this is extremely detrimental to total amount the investor will have at the age of retirement. ETFs are the perfect place for investors to start growing their retirement accounts. Chris from Figure 1 has great investment habits. He invests a total of $200,000 from the ages 25 to 65 and ends up with over a million dollars in his account by the time of retirement.
Furthermore, the U.S. Department of Labor defined benefit plans from employers are significantly decreasing over the past 30 years. Over the same period, defined contribution plans have risen, as shown in Figure 2. These trends make personal investment more important to many more people as the luxury of the defined benefit plan dwindles. Personal investment also becomes more important as workers are changing employers much more frequently than previous generations. A summary of an Executive Roundtable at the University of Southern California evaluates the millennial generation: “This generation is tech savvy and focused on personal fulfillment. They are less loyal, changing jobs more frequently than previous generations.” (SHRM). This impacts retirement plans because workers will be more inclined to use defined contribution plans so they can take their savings with them as they transfer jobs. ETFs are an important tool to empower these defined contribution plans as the plans become commonplace in the workforce.
Defining the Exchange Traded Fund
ETFs are unique in their diversification in that one can buy a single share that can potentially give you stake in several types of investments. Having this diversity is key to a strong investment portfolio. Mitch Kosev, economist at the Reserve Bank of Australia, defines ETFs as: “…securities backed by a pool of assets, the return on which is expected to track a specific benchmark as closely as possible.” (Kosev 51). ETFs are not only backed by individual stocks, but also by many different types of assets including stocks, bonds, commodities, and real estate. For example, one ETF could have one third of its portfolio in Apple Inc., one third in government bonds, and one third in Public Storage Real Estate Investment Trust (REIT). So, this ETF would have the diversity of three different types of investments that can be acquired through one single trade. Because of the volatility in various types of investments and individual securities, investors want to their portfolios to be diverse to minimize risk and volatility. ETFs become an attractive option for investors due to their diverse underlying securities.
Pricing ETFs is unique when compared to other investment options; ETFs act as a hybrid between stocks and mutual funds. This pricing scheme let ETFs reap some of the benefits from both stocks and mutual funds. An ETF’s net asset value (net asset value is the sum of all a fund’s assets minus liabilities, divided by the number of shares outstanding) is calculated at the end of each trading day. These net asset values embody the value of the underlying shares of the funds. When an ETF’s net asset value is $10.00 and the shares are trading at $10.10 it means that the shares are trading at a 1% premium, if shares were trading at $9.90 this would be a 1% discount to their net asset value (Wilmington). This pricing process is important to note because ETFs are still funds, but provide many of the trading advantages of stocks because they are traded on the open market.
Much like a stock, some ETFs provide dividends to investors. ETF dividends are a proportionate collection of the dividends of the underlying shares. There are two common ways that ETF providers use dividends. The first is keeping all the dividends in cash and paying them on the dividend date respectively. SPDR S&P 500 ETF $SPY employs this method, $SPY schedules quarterly dividends and pays out all the cash that it holds from the dividends it receives from the underlying shares. The second method is to reinvest the dividends in the same stocks as the index until the payment date. This leverages the ETF because in a sense, this money is borrowed from the investors. A comparison ETF to $SPY that employs this method is iShares Core S&P 500 ETF $IVV, $IVV also tracks the S&P500. $IVV does slightly better than $SPY in bull markets because the extra gains from the reinvested dividends. But the opposite is true in a bear market, the reinvested dividends end up in a greater loss. Either way the same dividend is paid out to the investor, but the value of the ETF is impacted based on the positive or negative returns of the reinvested dividends (Cummans). ETFs leave the investor with the option of reinvesting their dividends after the payment date or using them as cash.
Creation and Redemption of ETFs
The structure and creation of ETFs can provide many different benefits to investors. ETFs are created through what is called the “creation/redemption” mechanism. The process starts when an ETF provider teams up with an authorized participant (AP)—organizations with a lot of cash, usually banks such as Goldman Sachs or Morgan Stanley. Many APs can back a single ETF, most of the time there actually are multiple APs for a single ETF. The AP buys shares of stock from the open market in the correct proportion to the ETF that will be created, and then trades them with the ETF provider in exchange for a “creation unit” or block of usually 50,000 ETF shares. This exchange is made on the net asset value price not the current share price. The AP can then sell these ETF shares on the market for a profit. ETF shares can be removed from the market by the AP purchasing enough of the ETF shares from the market to form another block and then exchanging them with the ETF provider for the equivalent value in the shares that back the ETF (JP Morgan) (ETF.com). All the market trades by the AP are to other investors. Most trades on the market are kept blind to the public. The exception is when the investor holds more than 10% of the company or when the investor is a director or officer in the company. These trades can be viewed through the Securities and Exchange Commission by the public (Krantz). This information is available because these people know what is going on inside the company, their moves must be public to help level the playing field between the employees and outside investors. So investors do not know who they are purchasing securities, or ETF shares from when they are trading with the AP. They would only be able to see which AP is buying or selling the ETF at the time if the AP is a 10% shareholder.
Figure 3 demonstrates the creation/redemption process of the exchange between ETF shares, underlying shares, and cash. The underlying shares are what give value to the ETF shares; the ETF shares represent the total collection of underlying shares. By simply buying an ETF share on the stock exchange, the investor can easily access this unique collection of underlying securities that was designed by the ETF provider.
For ETFs, the creation/redemption process guides the ETF share price to stay equivalent to their net asset value, while maintaining efficiency. When the underlying securities net asset value of an ETF is priced at a discount to the ETF share price, the AP goes through the creation/redemption process and buys the underlying shares driving their price up, and creating more ETF shares, driving the ETF price down. When the underlying securities net asset value is at a premium to the ETF share price, the AP purchases ETF shares driving their price up, exchanges them with the ETF provider for the underlying shares, then sells the underlying shares driving their price down (JP Morgan) (ETF.com). This balancing act is extremely efficient and keeps the share price in line with the ETF’s net asset value. This is important because investors do not want to pay more than the ETF is actually worth. The indicative net asset value (IV) is an approximate measure of the net asset value that investors can use to help guide their trading decisions throughout the day (Wilmington). The unique construction of ETFs allows the price to stay closely aligned with the net asset value in an efficient manner.
The creation/redemption process provides ETFs with an advantage over closed ended funds. Closed ended funds do not permit an AP to create and redeem shares throughout the day. This leaves the closed ended fund price often far away from the fund’s net asset value, while ETF prices generally stay closely aligned thanks to the AP’s monitoring of the ETF share price (Proshares 4). This is beneficial to the investor because they will pay a closer price to the real value of the fund. Investors should know what they are buying and hopefully pay a fair price that has not been swayed far away from the net asset value during the day by supply and demand.
ETFs Compared to Other Investments
Along with the creation/redemption process, there are other advantages to owning ETFs over other types of securities. There are types of ETFs that track different pools of investment options, each of these types can provide the investor with an advantage over just buying the security flat out. Some holdings of ETFs can consist purely of, stocks, bonds, commodities, and real estate. For example, one of the main drawbacks to buying bonds is that there are penalties if the bond is cashed before maturity making the bond not very liquid. The iShares Core US Aggregate Bond ETF ($AGG) was created to represent the entire bond market in the United States. The largest allocation in this ETF is government bonds at 36.91% (TD Ameritrade) of the portfolio. This fund provides an advantage over owning individual bonds. Bond ETFs solve the liquidity problem of bonds by owning a vast number of bonds and having the fund pay out interest payments periodically, rather than the investor personally holding the bonds themselves.
A similar type of investment vehicle that ETFs are commonly compared to are mutual funds. Mutual funds are well known for being the investment tool of choice for inexperienced investors. These funds provide a way for investors to easily allocate their money in stocks and get a professional to manage their funds for them. ETF portfolios are picked by the managers, but differ from managed funds in that ETF assets are not selected depending on management’s decisions, they are created to track industries, indexes or markets. Mutual funds are a common way for new investors to enter the market. ETFs are a strong, new alternative for new investors to consider instead of mutual funds.
Combating Poor Investment Behaviors
The absence of human bias in investment selection is one of the reasons that some ETFs outperform some managed funds and individual investors. Financial analyst Mark Hulbert discusses the number of analysts that outperform the Wilshire 5000 Total Market index in a decade ending April 30, 2012, “Consider the 51 advisers out of more than 200 on the Hulbert Financial Digest’s list who beat the market…including reinvested dividends…Of that group, just 11—or 22%—have outperformed the overall market since then.” (Hulbert). Hulbert goes on to say that his Financial Digest’s list is no better than the percentage of all advisors, no matter how they have performed in the past. It is extremely difficult to beat the market, even for professionals, the choices the professionals make usually negatively impact their investments, these choices impede them from beating the market. The solution is to buy the market; this can be easily accomplished through ETFs. Buying the market allows the investor to avoid human bias in investment selection. ETFs allow the investor to do just this, simply by buying shares.
When emotion is involved in investment decisions it is usually detrimental to the investor, this makes ETFs a logical investment choice for investors. A 2005 study by Baba Shiv, a Stanford marketing professor, used gambling to display how fear causes people to avoid risky investments. The study was made so that logically the best thing to do was invest every round of the simulation. The study had 41 participants, out of these, 15 had brain damage that affected their emotions. These people invested 84 percent of the rounds averaging $25.70 gain by the end of the simulation. Normal participants invested 58 percent of the rounds making $22.80 by the end. There was also a control group that had brain lesions that was not involved in emotion processing and these people behaved similarly to the normal participants. Through further analysis the study observed that the emotional groups were reacting to the outcome of the previous round and getting scared to play again, rather than trusting the logic that it was beneficial to play every time (Stanford). Shiv’s experiment parallels a common phenomenon when it comes to investing. People tend to be “loss averse” which means that people are more sensitive to losses than gains. From 1926 to 1993, “…the annual real return on stocks has been about 7 percent while the real return on treasury bills has been less than 1 percent.” (Benartzi) (Investopedia). Yet people still invest in bonds for extended periods of time, often after a decline in the stock market—which is the ideal time to buy more stocks. This phenomenon of buying bonds over stocks, even though history indicates that is opposite is the better choice, is referred to as the “equity premium puzzle.” Shiv states that “Investors are not behaving in their own best financial interest. Something is going on that can’t be explained logically.” (Stanford). Antione Bechara, an associate professor of neurology at the University of Iowa goes far to theorize “…that successful investors in the stock market might plausibly be called ‘functional psychopaths.‘” (Stanford) Bechara says that it is common for successful investors to be better at controlling their emotions, or do not have as intense of emotions as normal people. Shiv goes on to say that “Many CEOs and many top lawyers might also share this trait… Being less emotional can help you in certain situations.” (Stanford). When it comes to investing, emotions can often play a detrimental role.
Loss aversion and the endowment effect cause people to make poor investment decisions. Dan Ariely, a Duke University Professor of Psychology and Behavioral Economics gives a YouTube presentation on these behaviors titled “Loss Aversion and the Endowment Effect.” Ariely states that on average people are 2.5 times more sensitive to losses than to gains. He uses the example of a coin toss bet, if the better wins they get $150 dollars and if they lose they lose $100 so the expected value is +$25, still most people do not take this bet. The endowment effect is when one owns something, it becomes more valuable to them. People feel as though they would have a greater loss if they lost the $100 than they would gain if they won $150, so they do not take the bet. Using Ariely’s proportion of humans being 2.5 more sensitive to losses than gains, the bet would have to be a gain $250 for a win, and a loss of $100 for a loss, before half of the people would take the bet. The second example Ariely uses is when he demonstrates the effects using a prepaid commission. In the example, there is a TV salesperson who has two different commission plans. Plan A: prepaid commission of $10 per TV. They would estimate the number of TVs sold and pay the salesperson in advance for the estimate, then if the salesperson did not sell all the TVs they were paid commission, for the TV supplier would take the commission for the TVs the salesperson did not sell back. Plan B: the salesperson makes $12 per TV after the sale. The better option is to sell the Plan B TVs because you gain $12 per TV instead of $10. The outcome of the experiment was that more people sell the Plan A TVs because they do not want to give back $10, more than they would like to gain $12 (Ariely). These effects can be carried over to investors who give up gains because they fear taking risks, and also investors who do not sell out of certain securities because they already own them, and value them more than they would otherwise.
ETFs provide a logical solution for combating loss aversion. ETFs eliminate the opportunity to be swayed by any emotions an investment manager has when trading or allocating funds. By design, ETFs mimic indexes and industries so there is no added emotion for the investor who is trying to get the best performance out of their fund by reallocating day to day. While fund managers and investors may be making loss-averse decisions that cut into their return, ETFs lock the investor into certain indexes and are not emotionally managed. ETFs encourage investors to decide and hold. Due to diversification, if one security in the ETF loses value, the investor will hardly notice and wait for it to regain its value. In sum, the stock market is extremely volatile short-term but long-term the market generally improves over time and has much less risk. ETFs encourage investors to buy an index or sector, and hold, without changing short-term allocations, impacting their return in a positive way.
Minimizing Extra Costs
Another major advantage to owning exchange traded funds over mutual funds is lower expense ratios. The expense ratio is the annual expenses an investor is charged by a fund. Both ETFs and mutual funds have expense ratios because they are both managed by companies, the fees go toward running these companies. The average ETF expense ratio, 0.44% (WSJ), is significantly lower than the average mutual fund expense ratio 1.25% (Morningstar). Factors that go into the ETF expense ratio are, paying the professional financial managers their salaries, and paying for the company to run (utilities, lease, etc.). Mutual funds charge their investors higher fees than ETFs. ETF providers charge much less than mutual funds because they focus on tracking indexes, so they do not require as much working power as the financial managers who try and get the maximum return. A 30-year investment of $100,000, with a 6% return reinvested each year, would be worth $506,842 with the average ETF expense ratio, and $402,078 with the average mutual fund expense ratio—a $104,765 or 105% difference in favor of ETFs due to compounding interest. The reason that people still pay for these mutual funds with extremely high expense ratios is the luxury of having zero investment effort. Mutual fund investors pay into a fund periodically and then they do not have to worry about managing their investments at all. ETFs are the next step closer to owning individual securities, because the investor must be conscious of what they are investing in when they buy the ETF.
Another cost added into the expense ratio is tax. ETFs end up paying some capital gains when they are forced to sell shares to keep up with index changes. But overall, the construction of ETFs provides an important tax-efficiency over mutual funds. The aforementioned creation/redemption process allows the ETF provider to avoid creating capital gains because the AP takes care of all of the trading during they creation/redemption process. So, the capital gains are passed on to the AP instead of the ETF provider (JP Morgan). If the ETF provider was forced to sell the shares when they wanted to take an ETF off the market, they would end up charging the investor a higher expense ratio because the process would create capital gains. Due to their construction, ETFs avoid or minimize paying capital gains distributions. This is important because any fees or taxes that an investor incurs over many years will compound to a large sum.
ETFs are also a more efficient way to gain exposure to the market, making them an attractive choice for any investor. Every time a person invests or removes money from a mutual fund there is overhead cost. When mutual fund investors are trading, they incur commissions and pay higher prices due to trading spreads. Overtime these add up and cut into the return of the fund. These fees occur in ETFs, but are once again, only charged to the AP because the AP does all the trading of the underlying assets. The AP also pays the ETF provider for the paperwork. All the costs are passed off to the AP, cutting the costs for the ETF provider, and in the end the investor. ETF investors still incur commission fees and encounter trading spreads when the ETF provider must trade to balance the index. Mutual fund investors end up paying when other investors choose the same fund because the fund must buy more shares directly, so a current investor is charged for new securities purchased because of the new investor (JP Morgan) (ETF.com). ETFs eliminate many costs of trade commissions and trading spreads that mutual funds encounter.
While mutual funds are locked into being traded only once per day, ETF investors can buy or sell any time the market is open. ETFs and mutual funds are traded based on their net asset value. Because of the vast number of assets that any mutual fund owns and the many trades that take place each day while managing the fund, it is hard to determine the price continuously throughout the day. This leaves mutual funds limited to being priced once per day, at the end of each trading period (Hansen). On the other hand, ETFs act on the open market the same way as a stock. It’s much easier to determine the value of ETFs because they do not reallocate their securities as often as mutual funds. This allows the investor to purchase any time throughout the day giving them greater investment power.
Mutual funds do have the upper hand when it comes to commission charged directly to the investor. Mutual funds can be bought into without brokerage commission fees. These (usually $10) trading fees can add up when constantly building one’s portfolio. For an investor that adds to their nest egg frequently, these fees add up to greater and greater costs. Depending on how much an investor buys, the loss from these fees can be a significant percentage of their portfolio that could have been invested, especially when keeping in mind the effects of compounding interest. These commission charges can be lessened with commission free ETF programs and low cost brokerages, but most of the time the investor must face commission charges.
Another trading contrast between buying mutual funds and ETFs is that an investor can buy fractional shares of a mutual fund. If a mutual fund is priced at $100 and an investor has $150 to invest they can buy 1.5 shares of the fund. ETFs can only be bought in whole shares. This aspect of mutual funds is an advantage to the minimal effort investor. Mutual funds are one of the investment tools that requires the least amount of effort. However, a barrier to entry for mutual funds is minimum initial purchase amounts. Most companies such as Vanguard and T. Rowe Price require initial purchases of at least $1000. ETFs in contrast have no minimum initial purchase. An investor could purchase just one share of an ETF, granted that the share price is within their purchasing power. This is helpful for the investor that is just starting their portfolio. Many brokerages also offer commission free ETFs, these programs breakdown the barriers to entry for new investors. ETFs are easily accessible with no minimum purchase besides the share price, ETFs must be bought in whole shares. In contrast, mutual funds have barriers to entry with minimum investment amounts, but can be bought in fractions of shares.
ETFs have the advantage of being traded on the open market, ETF providers are not forced to have any extra cash sitting in the fund, whereas mutual funds must have extra cash because they are traded between the fund and investor rather than on the open market. If many mutual fund investors want to cash in their shares on a particular day, the mutual fund must have the cash in order to buy them back—similar to a bank and withdrawals. These resources sitting idle cuts into the fund’s return as an added overhead cost. ETFs do not have this limitation because of being traded between investors rather than with the fund, leaving them with all their resources to invest and no idle cash—maximizing return. (Kahn)
Access to Diversification
Diversification is the most powerful reason behind buying into a fund of any kind. Diversification is important because it is impossible to predict exactly what will happen to a company. The dotcom bust in 2000 is a perfect example of why diversification is important to any investor. As the internet was expanding and gaining popularity in the American household, people quickly got behind these companies. An article in TIME magazine references Pets.com, “with sites like Pets.com — you know, the one with the cute sock-puppet mascot starring in the funny ads — getting big investors and gaining a place in American consumer culture” (Geier) Pets.com was one of the types of businesses that were gaining popularity during the dotcom bust. The NASDAQ is a tech-heavy index that grew 400% in the five years of 1995-2000. On March 11, 2000, the NASDAQ was valued at $6.71 trillion, on April 6 it was valued at $5.78 trillion—almost 14% drop to an index in less than a month. Pets.com went under—companies like Pets.com where reporting giant quarterly losses of between $10 and $30 million. Many times, popular investments end up going under. For this reason, diversification is an important tool to help investors prepare for collapsing markets. (Geier)
ETFs provide transparency and the greatest control when diversifying one’s portfolio with a fund. By design, ETFs track an asset class. It is easy for an investor to know what they are buying when investing in an ETF. The underlying securities of the ETF do not often change; this makes it easy for investors to keep track of what they are putting their money into. ETF investors are not plagued with having to keep track of what the underlying assets of their investment really are, compared to other funds that frequently trade the underlying assets. Effort is minimized, control is maximized.
Encouraging Knowledgeable and Ethical Investment
ETFs promote awareness of what securities the investor has their money in. Being ethical when investing is extremely important and often overlooked. There are other reasons to invest in a company then purely getting the maximum return. Due to their transparency, ETFs are suited well for upholding an investor’s ethical practices. Mutual fund managers are driven by return; this can cause ethics to be neglected when considering which companies to invest in. It is important for any investor to know what companies their money is enabling. While all fund investment promotes blind investing, ETFs make it easier to make conscious decisions when investing in companies compared with mutual funds.
ETFs and mutual funds can help investors be more ethical through the screening of investments. There are funds designed to invest in companies that are ethically or socially responsible. An investor that wants to make sure their money is enabling organizations that do good could simply buy one of these ETFs and relax. A good example of an ethical ETF is the iShares MSCI USA ESG Select ETF ($KLD), this ETF tracks the MSCI USA ESG Select Index (ESG stands for Environmental, Social, and Governance—the companies in the index have positive characteristics in these categories). This index is designed to account for a criterion of impacts that the organization makes on its stakeholders. There are five key categories that are considered when evaluating a company to be on the index, first is Environment: the index creator determines the impact that each organization has on the environment. Second is Community and Society: this screening determines how well the organization treats the local community and society that they come into contact with, this would include philanthropic and human rights issues. Third is Employees and Supply Chain: this examination considers how the management treats their employees along with anti-discrimination policies and practices. Fourth is Customers: this is about the quality and safety of a company’s products. Last is Governance and Ethics: this covers the company’s code of ethics, sustainability reporting, and board accountability (MSCI). All together, these categories filter out unethical companies to create an index that is comprised of more ethical and sustainable companies. By buying shares of $KLD an investor can easily access this index of ethical shares. Since this index is comprised of mostly S&P500 shares (less some unethical companies) it generally tracks the S&P500. Since more of an ethical company’s profits are going toward being ethical this ESG index slightly underperforms compared to the S&P500 (TD Ameritrade), this is a cost an investor realizes when only investing in responsible companies. It is important to note that these setbacks are not always the case, because some companies may gain from the publicity they get from being an ethical company. ETFs make it easy and cost effective for an investor to track a socially responsible index.
When comparing the ethicality of ETFs and mutual funds, it is clear that ETFs make it easy for the investor to have control, but also to be ethical due to their relatively static holdings. Mutual funds are constantly changing depending on the trades of the manager each day—this makes the investor prone to investing in companies they may not support. ETFs on the other hand, leave the investor much less vulnerable to blind investment. The underlying securities of ETFs stay the same, apart from changing in order to accurately represent their index. This allows the investor to be better informed and make more ethical decisions when deciding what their money is being used for.
Achieving Investment Goals
Different ETFs can be focused on achieving certain investment goals. Many ETFs simply track an index, like $SPY as seen in Figure 4 below. $SPY directly buys and holds the shares that back the S&P 500.
Other ETFs can have more conservative or aggressive allocations. The Core Conservative Allocation ETF ($AOK), tries to track the S&P 500 more conservatively. Since 38.6% of $AOK portfolio is corporate bonds (as shown in Figure 5), it underperforms in bull markets and outperforms in bear markets (see late 2011). This ETF minimizes volatility while ensuring the investor still gets a return. This ETF could be used when an investor suspects a bear run and wants to minimize losses but maintain a market presence.
iShares Core Aggressive Allocation ETF ($AOA) is somewhat like $AOK in that it tracks the overall market on a more conservative basis but is slightly more aggressive than $AOK. This ETF could be used by an investor willing to take on more risk but still does not want to match the risk of the market. Figure 6 shows that $AOA has outperformed $AOK in recent years because of the bull market run. Although $AOA still does not match the S&P 500 index.
So, what if an investor wants to incur greater risk and bet on a bull run instead of a bear run? Leveraged ETFs are a risky tool to use for betting on bull runs. These ETFs use margin trading and other leverage tools to magnify the return on an index. The Direxion Daily S&P500 Bull 3X Shares ETF ($SPXL) seeks to magnify the performance of the S&P 500 by 300%. The goal of $SPXL is to match three times the daily returns of the S&P 500. Figure 7 displays the 5 year returns of $SPXL when compared to the S&P 500. The fund does a great job of amplifying the gains of the index, the 300% match is not guaranteed. The risk of these types of ETFs is observed during the bear market as they are three times more sensitive than the index. Figure 8 displays the returns of the same bull ETF, $SPXL, over the past year when compared to the S&P 500. The losses outweigh the gains in this case and the investor would end up with greater losses than if they just invested in the S&P 500. (Direxion)
ETFs Tailored to Investment Stages
ETFs can be used in a variety of different ways depending on the needs of the investor. Age is one of the most important factors when determining what level of risk one can take on, and what type of returns one would prefer. Young people can take on a great amount of risk because they have lots of time to gain back any losses. People nearing retirement want low risk investments because they do not have time to gain back their losses if the market takes a bear run. While middle-aged people need a moderate combination of risk. Age is also accompanied with experience, the contrasts the risk allocations of young taking more risk and middle aged taking a moderate amount of risk. The young investor may not have much experience so they should make less risky investments, while the middle-aged investor has more investment experience making them able to carry more risk. There are two types of return an investor can get from investing in ETFs—increased value return and income generating return. The investor can sell the ETF when it has increased in value for more than they bought it for, this type of return has higher risk because the investment could lose value over time. The second type of return is income generating. This could come in the form of dividends from underlying shares of stock, or interest from the underlying bonds and other loans. This type of return is not as risky to rely on and gives the investor cash to use however they wish, whether that be reinvestment or as working capital.
ETFs are the perfect investment tool for the young investor. With no minimum purchase and commission free trading programs, ETFs are extremely accessible to a young investor. ETFs also provide fund advantages of diversification, and lower investment effort. SPDR S&P 500 ETF $SPY is a good example of an ETF that a young person can feel confident buying. Looking back to general market returns, the investor can undertake the risk of short term market volatility and buy the market expecting to get around 7% (Benartzi) per year in the long term, in the form of value and reinvested dividends. By buying index tracking ETFs like $SPY, the young investor can gain access to these 7% long run returns with minimal effort and low fees.
Once the investor has more investment experience, ETFs can be used as a tool to track different industries and sectors that the investor thinks will do well. By this stage in life the middle-aged investor has more experience and can make better investment decisions. This middle-aged investor can invest in ETFs that will gain in value from increased share value or income. For example, if the investor thought the internet sector was going to do well over the next decade they could by the First Trust Dow Jones Internet Index Fund ($FDN). The top holdings of $FDN include Amazon, Facebook, Netflix, and Google (TD Ameritrade). This would empower them to buy the entire industry that they think will do well.
As an investor nears retirement age, they must start allocating more money to lower risk and income generating investments. As stated earlier, hopefully the investor has started saving early and has enough saved to live off. One can hope that they will be able to live off their income generating investments for the rest of their lives. ETFs make it easy to accomplish this through buying income generating funds such as dividend ETFs or bond ETFs. For example, an investor wanting to diversify their bond investments could buy the iShares Core US Aggregate Bond ETF ($AGG). This bond ETF would give those close to retirement age security and income in a diverse collection of US bonds.
Buying ETFs is as simple as starting a brokerage account, adding funds, and making a trade. Trading an ETF is the same experience as trading a stock, this is unlike other funds where investors pay directly into the fund. ETF investors do not have to directly interact with the ETF provider at all. Different brokerages have different commission charges so the cost of buying the ETF could vary depending on the brokerage. Most brokerages charge around $10 commission per trade, so the cost of buying and selling an amount of an ETF would be approximately $20 depending on the brokerage. There are many different research tools that brokerages provide to educate their investors on which ETF would be right for them. Some brokerages are commission free, but they provide less research tools and poor customer service when compared to the brokerages that charge commission. The differences between buying ETFs through different brokerages comes down to, customer service, research tools, commission costs, and commission free ETF trading programs.
It is important to start personal investment early to maximize return, and because the trend of declining number of defined benefit plans and increasing number of defined contribution plans is increasing the importance of personal investment plans. ETFs are a great tool to use when building a personal investment portfolio. ETFs are funds that are traded on the stock exchange. There many types of ETFs that can be made up of many different types of securities—the most common being stocks. The creation/redemption mechanism that ETFs employ provide them with many fee, tax and trading advantages when compared to other funds because the costs can be passed off to an AP. ETFs also combat loss averse tendencies of investors through encouraging investors to buy and hold. ETFs are transparent, giving the investor control over investments and discouraging blind investment, making ETFs an ethical investment option. There are many different goals that can be accomplished through ETFs, from only investing in socially responsible companies, to tracking the internet sector. Buying ETFs is as easy as buying a stock through a brokerage. ETFs are effective investment vehicles that empower average and inexperienced investors. Investors should start investing as soon as possible and consider ETFs as a tool to use throughout their entire lives to empower their investment activities.
- Antoniewicz, Rochelle. “The Role and Activities of Authorized Participants of Exchange-Traded Funds.” Investment Company Institute (2010): 245-62. Mar. 2015. Web. 5 Nov. 2015. Link.
- Benartzi, Shlomo, and Richard H. Thaler. Myopic loss aversion and the equity premium puzzle. No. w4369. National Bureau of Economic Research, 1993.
- “Bid-Ask Spread.” Morningstar. Morningstar, n.d. Web. 17 Oct. 2015. Link.
- “Bonds & Bond Investing - Fidelity.” Fidelity.com. Fidelity, n.d. Web. 19 Oct. 2015.
- Bricker, Jesse, Lisa J. Dettling, Alice Henriques, and Joanne W. Hsu. “Changes in U.S. Family Finances from 2010 to 2013: Evidence from the Survey of Consumer Finances.” Federal Reserve Bulletin (2014): n. pag. Federalreserve.gov. Federal Reserve, Sept. 2014. Web. 1 Nov. 2015.
- “Creation and Redemption.” JP Morgan Thought Magazine. JP Morgan, Summer 2008. Web. 2 Nov. 2015.
- Cummans, Jared. “Do ETFs Pay Dividends?” ETF Database. N.p., 24 June 2015. Web. 27 Nov. 2015.
- Damato, Karen. “What Exactly Are 12b-1 Fees, Anyway?” WSJ. Wall Street Journal, 6 July 2010. Web. 11 Nov. 2015. Link.
- Direxion. “Daily S&P 500 Bull 3x Shares.” Direxion ETFs | Funds. Direxion, n.d. Web. 20 Nov. 2015.
- “Exchange Traded Funds (ETFs).” Khan Academy. Khan Academy, n.d. Web. 10 Oct. 2015. Link.
- “Expense Ratio.” Expense Ratio. Morningstar, n.d. Web. 15 Oct. 2015. Link.
- Geier, Ben. “What Did We Learn From the Dotcom Stock Bubble of 2000?” Time. Time, 12 Mar. 2015. Web. 5 Nov. 2015. Link.
- Hansen, S. Wade. “Mutual Funds 101.” Forbes. Forbes Magazine, 23 Aug. 2006. Web. 22 Oct. 2015. Link.
- “How to Choose an Exchange-Traded Fund (ETF).” WSJ. Wall Street Journal, n.d. Web. 11 Nov. 2015. Link.
- Hulbert, Mark. “Man vs. Machine: The Great Stock Showdown.” Wall Street Journal. Wall Street Journal, 10 May 2013. Web. 1 Oct. 2015.
- Investopedia Staff. “Mutual Funds: The Costs.” Investopedia. N.p., n.d. Web. 10 Oct. 2015. Link.
- Kosev, Mitch, and Thomas Williams. “Exchange-traded funds.” RBA Bulletin, March (2011): 51-59.
- Krantz, Matt. “How Can I See Who’s Selling a Company’s Stock?” Usatoday.com. USA Today, 6 Sept. 2012. Web. 6 Nov. 2015. Link.
- Mladjenovic, Paul J. Stock Investing for Dummies. Hoboken, NJ: Wiley, 2013. Print.
- MSCI. “MSCI USA ESG Select Methodology.” Index Methodology (2011): 2. Www.msci.com. MSCI, May 2011. Web. 27 Nov. 2015.
- “Mutual Fund Expense Ratio Trends.” Morningstar (2014): 1-4. Corporate.morningstar.com. Morningstar, June 2014. Web. 15 Oct. 2015. Link.
- NAREIT. “What Is a REIT?” REIT.com. NAREIT, n.d. Web. 18 Oct. 2015.
- ProShares. “Nine Questions Every ETF Investor Should Ask Before Investing.” (2012): 4. UnderstandETFs.org. ProShares. Web. 23 Nov. 2015.
- Pylypczak-Wasylyszyn, Daniela. “The Best S&P 500 ETF: SPY vs. IVV vs. VOO”. ETF Database. ETF Database, 24 Apr. 2015. Web. 20 Nov. 2015.
- Pylypczak-Wasylyszyn, Daniela. “The Hidden Costs of ETF Investing.” ETF Database. N.p., 24 June 2015. Web. 10 Oct. 2015. Link.
- Shreck, Mara, and Shelly Antoniewicz. “ETF Basics: The Creation and Redemption Process and Why It Matters.” ICI. Investment Company Institute, 19 Jan. 2012. Web. 17 Oct. 2015. Link.
- Simpson, Stephen D. “A Brief History of Exchange-Traded Funds.” Investopedia. Investopedia, 2 Nov. 2015. Web. 20 Nov. 2015.
- Simpson, Stephen D. “Evaluate Your Investments with SWOT Analysis.” Investopedia. Investopedia, 05 Apr. 2011. Web. 5 Oct. 2015.
- “SPY SPDR S&P 500.” SPY ETF Guide. ETFdb.com, n.d. Web. 18 Oct. 2015.
- Stanford GSB Staff. “Baba Shiv: Emotions Can Negatively Impact Investment Decisions.” Stanford Graduate School of Business. Stanford Graduate School of Business, 1 Sept. 2005. Web. 5 Oct. 2015.
- The Street. N.p., n.d. Web. 5 Nov. 2015. Link.
- “What Are the Interest Rates for Federal Student Loans?” Studentaid.ed.gov. US Department of Education, n.d. Web. 1 Nov. 2015. Link.
- “What Is the Average Annual Return for the S&P 500?” Investopedia. Investopedia, 24 Apr. 2015. Web. 7 Oct. 2015.
- “What Is the Creation/Redemption Mechanism?” ETF.com. N.p., n.d. Web. 2 Nov. 2015. Link.
- Wilmington Trust. “The Valuation of Exchange-traded Funds.” Wilmington Trust. Wilmington Trust, n.d. Web. 28 Nov. 2015.
Find an error in this post? Any updates are appreciated. Edit this post