Exchange-Traded Funds (ETFs)

Exchange-Traded Funds or ETFs have revolutionized the way you invest your money, along with the wealth management industry in general.

And for good reason. They offer retail investors like you access to assets, strategies, and liquidity, all in one. Before their advent, you could only rely on classic mutual funds or implementing strategies on your own.

ETFs provide all sorts of benefits, such as wide diversification at a very low cost. For this reason, it’s crucial that you understand what they are and how they work.

The good news is that if you know nothing about them, this guide is a great start. After you go through it, you will:

  • Understand what types of ETFs exist,
  • Know where to buy them from, and
  • How to select the right ones for you

Let’s cover the basics first, though…

ETFs Explained

An Exchange-Traded Fund (ETF) is pooled money that professional investors manage in the form of a security listed on a stock exchange. In other words, ETFs are stocks that give you access to other assets; these can be stocks, bonds, commodities, etc.

When you buy an ETF, you basically buy equity into a portfolio invested in other assets. If an ETF includes stocks, for example, buying it would make you an indirect owner of all the underlying stocks it holds.

What’s very unique about ETFs is their form. As we mentioned, they’re listed on stock exchanges, so there’s practically no difference between the way you trade them and stocks.

ETFs have shares that are traded back and forth via stock exchanges like Nasdaq and NYSE. When you buy ETF shares, you indirectly buy them from another seller. In the same way, you can sell them in the open market.

Of course, since an ETF is a fund that others manage, there’s a cost associated with holding one. Similar to how you would get charged if you bought a mutual fund, managers will take a small percentage of the amount you have invested every year.

Let us now dive into the types of ETFs and talk about the costs associated with each one so you can get an idea…

Passive ETFs vs. Active ETFs

The types of ETFs are far too many, but there are only two main categories that you need to be aware of. That is because these are where all types come from.

Active-and-Passive-ETF

Passive ETFs

Passive ETFs (or Index ETFs) are ETFs that track market indices. Let’s take a moment to explain indices first.

A market index is simply a measure of a market’s performance.

Take the S&P 500 for example. This widely known index measures the total performance of the largest 500 companies in the United States. It’s classified as a broad-market index because the 500 companies it tracks (which change all the time based on specific criteria) are supposed to represent the US economy as a whole.

But there are all sorts of indices. There are indices that track the performance of sectors from Real Estate to Information Technology. But it’s not just markets that indices track. There is also an index that tracks companies that were spin-offed by their parent companies (S&P U.S. Spin-Off Index).

Now, passive ETFs are essentially funds that are set up to mirror the performance of an index. They do that by managing a portfolio that is identical to the holdings the index has at any time.

This, of course, implies that all managers have to do is watch closely for any change in an index’s holdings and act accordingly. For example, say that a hypothetical stock named AAA doesn’t fulfill the criteria of the S&P 500 index anymore and is replaced by one called BBB. The managers of an ETF that tracks the index will have to sell AAA and buy BBB to match their performance with the one the index measures.

It naturally follows that because of costs and a delay in trading the assets included in an index, the index ETF’s performance will deviate from that of the index itself.

TIP: To check how well an ETF matches the performance of the index it tracks, look for its tracking error.

This is essentially the difference between the return of the index and that of the ETF. If, for example, an index returned 10% in a year and the ETF returned 9%, the tracking error is 1%. The lower the better.

Cost of Passive ETFs

As you can imagine, these ETFs are called passive because the strategy the managers employ itself is passive in nature. For this reason, the costs associated with running such a fund are very low. In turn, investing in such ETFs is very cost-effective as well.

A common metric used in the asset management world is the expense ratio. It’s basically the percentage of the assets under management that wealth managers charge their investors each year. If you invest $1,000 in an ETF that charges a 1% expense ratio, your annual expense would be $10, for instance.

But Index ETFs have very low expense ratios. You can expect to pay something ranging from 0.04% to 0.4%. That’s a rule of thumb, of course, and many asset managers will charge even less or more.

But it’s generally uncommon to see passive ETF expense ratios higher than 0.5%. Especially if they track broad-market indices like the Dow Jones or the S&P 500, for which there’s a lot of competition.

Active ETFs

Active ETFs, on the other hand, are all the ETFs that don’t track an index. Most of them employ strategies that aim to beat a market index instead. The essential thing to remember here is that active ETFs are invested according to some proprietary investment strategy.

Such funds could be using trading algorithms or industry insights to find inefficiencies in the market and profit from them.

Take for example the ARK Innovation ETF (ARKK). The ETF buys companies which it forecasts will profit from “disruptive innovation”. The success of this ETF depends on the managers’ ability to identify such investment opportunities.

Another example would be the Fidelity Blue Chip Growth ETF which invests in US large-cap stocks the managers think have been mispriced by the market.

Cost of Active ETFs

Naturally, active ETFs will charge investors more than passive ETFs do. This is to be expected as their work is more complex (research, valuation, and portfolio management).

With active ETFs, you can expect to pay anything from 0.5% to 1% annually. It’s uncommon to see expense ratios above that range here.

But the cost depends on the complexity of running the fund. For instance, the JPMorgan Ultra-Short Income ETF has a 0.18% expense ratio while employing an active strategy. This is actually lower than what other passive index funds charge.

In contrast, the ARK Innovation ETF charges 0.75% on its AUM. But it does attempt to provide investors with a much better return.

For this reason, the conclusion that active ETFs are more expensive than passive ones is based on the fact that passive strategies are generally more cost-effective than active ones. But this is not always the case. That’s why you should remember that there are exceptions.

Where to Buy ETFs

Getting access to ETFs is easy. There are chances that your bank will give you access to many of them if you want to go the traditional route.

Of course, if you want to make sure that you get access to a large variety of ETFs to choose from, open a brokerage account.

Brokers like Fidelity, Interactive Brokers, Charles Schwab, TD Ameritrade, and others allow you to buy ETFs from all over the world.

Make sure that the broker you choose gives access to ETFs before you open an account. But more importantly, confirm that you will get access to the ones you want to buy.

What to Look for When Investing in ETFs

Fortunately, the due-diligence you need to do to pick ETFs is straightforward.

You surely don’t have to have broad financial knowledge and experience to intelligently invest in one. You only need to understand a few concepts.

Just use the checklist below and you’ll be good to go…

Asset Class

First, determine what you want to invest. Is it stocks, bonds, or maybe commodities? There are also ETFs that invest in a combination of assets.

Deciding the asset you want to buy is the first step in narrowing down the list.

Strategy

What kind of strategy do you want the managers to run? We discussed the two ETF types above; active and passive.

If you select an index that you want to track, that will be straightforward.

But you need to be more specific if you decide you want active management. There are all sorts of strategies that aim to beat the market. Some ETFs short (or bet against) stocks. Some others diversify across multiple assets to keep volatility low while trying to beat the market.

Remember that you need to choose a strategy that you can understand well before you invest in an actively-managed ETF.

Volume

If you require liquidity in the ETF you buy, you also have to look at trading volume. This shows how many interested buyers and sellers are at any time. All brokers will show you this if you browse ETFs on their platforms.

This is not very important unless you think you will need to sell shares of the ETF frequently for personal needs. If an ETF has a low volume, you may not be able to do this fast enough or at the price you want.

Expense Ratio

We already talked about the expense ratio above, but as a reminder it’s the annual cost a fund like an ETF charges on your invested capital, expressed as a percentage.

Active ETFs will generally charge a higher expense ratio than passive ones, but there are exceptions.

Expense ratios can range from as low as 0.1% to as high as 1%. The lower the better, of course, but you should also look at the cost in relation to the following two factors…

Historical Returns

It goes without saying that when comparing ETFs of the same type that employ a similar strategy, the ones with the higher returns in the past will be the more attractive.

By the same token, new ETFs with no history are less attractive to the ones that have been operating for some time.

Of course, historical returns are not indicative of future ones. But they are often a good indicator of management quality.

Turnover

Last but not least, you need to look at the turnover ratio of an ETF. This is basically the percentage of the ETF’s underlying assets that are replaced each year.

This is basically the silent fee in the world of mutual funds and ETFs. That’s because of the transaction fees associated with buying and selling assets which will negatively impact performance.

There can also be a more indirect cost related to taxes. If an ETF buys and sells an asset within a year, gains will not qualify for capital gains tax (which in many countries is lower than the income tax rate).

You can generally expect passive ETFs to have relatively low turnover ratios (10% – 30%). But actively managed ETFs can run as high as 100% if they employ a trading strategy.

A high turnover ratio may not necessarily be a bad thing, however. Some actively managed ETFs will run strategies that will require them to buy and sell assets more frequently in an effort to outperform the market.

But as a rule of thumb, the lower the better.

Conclusion

As you can see, Exchange-Traded Funds are not complicated investment vehicles. They are similar to mutual funds in that they allow you to delegate to a professional to manage your money.

But they are unique in that they are so cost-effective and liquid. The ETF market has grown so much that there are all sorts of ETFs that you can find.

This guide was supposed to give you an overview of the world of ETFs so you can know how to navigate through the various offerings out there a bit easier.

The research required when it comes to selecting ETFs is simple and mostly everyone can do it.

At the same time, it’s also fortunate that you will not have to do it many times. Once you pick the ETFs that fit your investment needs, all you need to do is keep track of their performance.