Since their introduction, exchange-traded funds (ETFs) have become a popular investment vehicle and the number of ETFs available has grown rapidly. One way to think of ETFs is as baskets of stocks, like mutual funds, but you can buy and sell them on the exchanges intra-day like stocks. Learn more about ETFs through the ETF Center, powered by Morningstar®. Once confident in your knowledge, as a Siebert client you can review our ETF Research, which includes an ETF Screener and Profiles from Interactive Data Corporation. Quickly review ETF performance data, holdings and other detailed information to help you make an informed investment decision.
What are exchange-traded funds, and how do they
stack up against the competition?By Morningstar
Even though exchange-traded funds have been around for two decades now, they’ve really caught on with investors only over the last few years. But they’ve caught on in a big way. The market has grown by leaps and bounds, and investors now have hundreds of ETFs from which to choose. It's always good to have choices, but at some point, too many options can become overwhelming.
Let's cut through the confusion by focusing on the basics. Armed with a clear understanding of how ETFs work, as well as their strengths and weaknesses, you’ll be better equipped to sort through the options and make smart investment decisions about how to incorporate them in your portfolio.
The Basics At a very basic level, ETFs aren’t difficult to understand. Most are essentially index funds. Granted, some track rather exotic benchmarks, but they are index funds, nonetheless. ETFs are different than conventional index funds in the way they are bought and sold. An ETF is traded throughout the day over an exchange, just like a stock. That means you can execute market, limit, and stop-loss orders for ETFs, just as you can with individual equities. You can also sell them short or buy them on margin (i.e., with borrowed money), and it's even possible to trade options on many ETFs.
That trading flexibility is one of the reasons ETFs have captured investors’ attention. But ETFs possess other advantages that are far more important than the ability to sell them short or trade options against them. In order to understand all that ETFs bring to the table, we first need to delve into the specifics of their structure. So let's take a look under the hood.
The Mechanics When you invest in a mutual fund, you (or your advisor) purchase shares directly from the fund company at a price equal to the fund's net asset value, which is calculated at the end of each trading day based on the market prices of the securities held by the fund. However, buying and selling ETFs works differently. Rather than dealing directly with the fund company, you buy ETF shares from another individual investor over an exchange at a price determined by supply and demand, not the ETF's underlying NAV.
In the ETF arena, individuals do not deal directly with the provider, such as Vanguard, State Street, or iShares. That privilege is reserved for a few very large investors, called “authorized participants.” When these authorized participants want to sell ETF shares, they hand their shares over to the provider and, in return, receive the underlying portfolio of stocks. No cash changes hands. The same process works in reverse for purchases. The authorized participant assembles a portfolio of stocks (in the same proportion that they are held in the ETF) and delivers it to the ETF provider, who then hands over new ETF shares.
This “in-kind” redemption and creation process helps keep an ETF's market price close to its NAV. If discrepancies arise between a fund's market price and its NAV, that opens up a profit-making opportunity for an authorized participant. The very act of exploiting that opportunity drives the market price and NAV closer together.
It's easier to understand if we look at a specific example. Let's say an ETF is trading at a discount (in other words, its market price is less than its NAV). A large institutional investor can purchase shares of that ETF in the open market at its discounted market price, then redeem them in kind to receive the underlying stocks in the portfolio. That investor can make a quick profit by selling all the stocks, which, cumulatively, are selling at a higher price than was originally paid for the ETF shares. These large sell orders place downward pressure on the price of the underlying stocks, while the original purchase order for the ETF pushes its market price higher until, ultimately, the discount is eliminated.
For this process to work effectively, the underlying securities need to be liquid. If an authorized participant has trouble trading the underlying securities, the share price of an ETF and its NAV could diverge. This could be a concern for ETFs that traffic in less-liquid securities.
Large investors are constantly monitoring the ETF market to take advantage of discounts and premiums when they develop. A high degree of transparency is required to make this process possible so that the authorized participants are always aware of what each ETF owns and what its shares are worth. Consequently, ETFs are required to publish their NAVs every 15 seconds throughout the trading day.
ETF Dangers ETFs hold a lot of promise, but they also court certain dangers. Some ETF marketing literature plays up the fact that ETFs can be used for short-selling and options trading. We frankly don’t consider that a big bonus. We see these strategies primarily as tools for speculating rather than investing. Most options and shorting tactics require accurate short-term market calls, which are almost impossible to make with any consistency. Consequently, those looking to make a quick buck on options or short trades are likely to get burned. In fact, some strategies, in theory, have the potential for unlimited losses. While many options trades are best avoided, there are some conservative strategies that can be used to limit losses or lock in profits.
We're also concerned that narrowly focused ETFs will attract performance-chasers. Many of these funds are quite concentrated and volatile, and they can swing from exhilarating highs to gut-wrenching lows. While double-digit returns are certainly tempting, it's unrealistic to expect a hot-performing ETF to engineer repeat performances year-in and year-out. In fact, by the time investors catch on to a hot market segment, the rally is often on its last legs. At Morningstar, we tend to approach investing from a contrarian point of view, avoiding those areas that have attracted scads of investors in favor of those that have flown below the radar.
Niche ETFs can also entice some investors into thinking that they can time the market by quickly rotating in and out of funds, trying to capture short-term rallies while escaping the downdrafts. But that's a difficult game to play, and we think very few investors can make those calls with any consistency.
Plus, it's expensive. As with stocks, you typically pay brokerage commissions each time you buy and sell an ETF. Overenthusiastic traders can see their profits wiped out quickly by commission costs. At Morningstar, we tend to be long-term investors. We’d rather own stocks and funds rather than rent them. It's particularly important to have a long time horizon when using ETFs because of trading costs. For the same reason, ETFs aren’t the best vehicle for investors who make a lot of small purchases.
The Upshot ETFs have powerful advantages that many investors can profit from. But like anything else, their advantages fade quickly if they are used inappropriately. Investors who trade often and indiscriminately will see ETFs’ cost advantage eroded by brokerage commissions. Similarly, frequent trades generate tax consequences that offset ETFs’ tax-friendly structure.
Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.
© Copyright 2013 Morningstar, Inc. All rights reserved. Morningstar, the Morningstar logo, Morningstar.com, Morningstar Tools are either trademark or service marks of Morningstar, Inc.