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Everything You Need to Know About an Index ETF

02/15/2019

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ETFs (exchange traded funds) have become very popular investment tools in recent years. The use of ETFs has only been around for a few decades but these funds have already amassed global assets totaling $5 trillion.
That is shocking growth for what is a relatively new form of investment vehicle.
What draws investors to an index ETF and how are these funds different from the many different investment options available?
In this article, we will take a close look at everything investors should know about an index ETF before they make their next investment decision.

What is an Exchange Traded Fund?

Many investors are familiar with mutual funds. For new investors that walk into a bank or financial institution, mutual funds are typically what is offered. These funds pool together money from investors and buy assets using that money. When an investor leaves, a mutual fund must pay out the investor and this may incur some fees for selling assets.

On the surface, an exchange traded fund is a lot like a mutual fund. These massive funds hold a large basket of assets that can be reflective of whatever the fund manager has determined will be important for the fund in question. For example, an index ETF will track a specific index like the S&P 500. This is much like an index mutual fund can be created to track a specific index as well.

However, the way that ETFs are bought and sold by investors is one of the largest differences between these funds and a mutual fund. Instead of investors pooling their money into the fund, the fund sells shares much like a company would issue stock. These shares can be bought and sold on the open market. If an investor would like to sell their stake in the ETF then they can sell their shares on the market which makes the individual seller, not the fund, responsible for commissions and capital gains.

How Does an ETF Acquire Assets?

One of the most common ways an ETF will acquire assets to hold is by using creation units. Instead of buying assets and incurring the associated fees, an ETF will create additional shares which can be traded to an authorized partner that, in turn, provides the assets the fund manager required.

This is a huge difference between an ETF and a similarly structured mutual fund. An ETF has a method by which it can successfully avoid and limit fees for their investors.

What Are the Advantages of an Index ETF?

So, why would an investor consider an index ETF when compared with a similarly structured mutual fund? One of the main reasons investors are drawn to ETFs is their low cost structure. The method by which investors can purchase shares of an ETF and sell those shares on the open market limits the need for the fund to continually buy and sell in order to manage individual investor movements. As a result, these costs are not passed on to the rest of the investors who hold shares in the ETF.

In addition, ETFs are not prone to fees that can arise as a result of herd mentality. If investors buy or sell a number of ETF shares, then the fees will not be passed on to other investors holding those shares. Of course, price changes will affect portfolio value but these short term changes in price will not affect investors in the short term as much as fees would.

However, it is important to note that not all ETFs necessarily offer low fees. While management fees may be low, there are active ETFs that make regular trades if deemed necessary. These funds can still incur fees and capital gains that must be passed on to investors. If low cost funds are important for you, it’s advisable to look at the history of total fund fees to determine if the ETF maintains a low fee structure.

ETFs also give investors a simple way to diversify their holdings and track a number of different indexes or industries without having to build a large, complicated portfolio from scratch. By purchasing one ETF share, investors can get exposure to many different companies that are part of a single index.

What Are the Disadvantages of an Index ETF?

Like any other index product, an index ETF can have what is known as tracking error. This is the difference between the performance of the index fund and the actual index it was designed to track. If investors are expecting an index ETF to directly match the returns of the index that are likely to be disappointed. Tracking errors can be small or large, depending on how closely the fund has actually been structured to the index.

Since ETF shares are traded on the market, investors that buy and hold these shares can avoid many of the fees that arise from other investors buying and selling. Of course, this does not make them immune to overall price changes as the market dictates. In fact, depending on market movements, an index ETF can actually have a lower value than its net asset value. This means the price of outstanding shares is not reflective of the market value of the underlying assets held by the ETF.

This price differential, if great enough, can drive institutional buyers to acquire a large number of shares to resell at a profit. Individual investors can also purchase ETF shares that fall below net asset value if they have identified a strong buying opportunity. While finding shares fall below net asset value may be a disadvantage while holding the shares, it can be a great advantage for those looking to buy. In addition, this difference in value is not often long lasting as the opportunity is seized upon by other buyer.

Another downside of an index ETF is that the fund is designed to simply track an index and there is no attempt to pick winners and losers. As a result, some of the assets held by the fund may end up being of lesser quality than other assets. This is in contrast to more active funds where managers will try to pick out the winners and ignore the losers in the market. Depending on performance, investors may end up leaving money on the table by trying to reduce fees through an index ETF.

Using Index Exchange Traded Funds as Part of Portfolio Construction

Index ETFs can be an important part of many different types of portfolios. These ETFs give investors exposure to indexes or industries they feel are an important part of their portfolio. While investors may not want to construct an entire portfolio of index ETFs, they can be a solid foundation from which to develop a successful portfolio.

One of the great benefits of an ETF is that it provides diversity and exposure with a single, simple security. With just a few different ETFs, investors can quickly diversify their portfolio much like they would with mutual funds. This is simply another option for investors as they begin the portfolio construction process and it is always better for investors to have more options rather than less.

However, an entire portfolio constructed of index ETFs may not be the right solution for many investors. By focusing only on index ETFs for an entire portfolio, investors could unintentionally be missing out on other opportunities or introducing a significant portion of their portfolio to unnecessary risk. Just like individual stocks, bonds, and other investments, ETFs in a portfolio must accurately reflect the risk appetite and goals of the investor in question.

When mixed with other investments, ETFs can be a great way to reduce total portfolio fees and provide a stable and easy way to track indexes.

Is an Index ETF Right for Your Portfolio?

Every investor has their own unique needs and goals. It’s impossible to say with certainty if an index ETF is the right choice for an investor without further understanding their situation. However, they are often a very important piece of overall portfolio construction.

If you are interested in learning more about index ETFs and other investment options, please contact Linden Thomas and Company today.

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