Why Use ETFs?

Exchange Traded Fund

An ETF is an Exchange Traded Fund. Let’s dive into the purpose that an ETF may serve in an investment portfolio, their adoption by investors, their tax implication, and more.

Table of Contents:

    What Are ETFs?

    How Common are ETFs?

    The Difference Between Active ETFs and Passive ETFs

    How are ETFs Traded?

    What Expenses are Associated with the Use of ETFS?

    Are There Transparency Benefits to ETFs?

    What Tax Efficiency May ETFs Have?

    Do Most Investment Advisors Use ETFs?

    Who Regulates ETFs?

    What are ETFs?

    Exchange Traded Funds are a popular investment vehicle for all types of investors. ETFs are pooled investment securities that can be bought and sold like an individual stock. 

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    Exchange Traded Funds, usually referred to simply as ETFs, are financial instruments that combine the diversification benefits of mutual funds with the ease of stock trading. Like mutual funds, ETFs are professionally managed, diversified portfolios of stocks, bonds, or other assets. However, while mutual funds can only be traded at the close of trading each day, ETFs trade on exchanges and can be traded throughout the day.

    Financial advisors increasingly prefer using ETFs as their building blocks for constructing investment portfolios. ETFs offer diversification, liquidity, and ease of trading compared to individual stocks, bonds, and mutual funds.

    How Common Are ETFs?

    ETF adoption has grown in recent years, in terms of both the quantity of ETFs available as well as the amount of asset invested in ETFs. The top 3 ETFs by AUM represent over $1 trillion as of December 31, 2023.

    The first U.S. ETF debuted in 1993. Since then, the popularity of ETFs has exploded, especially over the last decade. Today there are over 2,000 ETFs available in the US. Between 2016 and 2022, use of ETFs grew by 16% annually. Analysts at Oliver Wyman estimate that ETFs will surpass $12-16 trillion in “assets under management” (AUM) by 2027.¹

    Financial advisors have found ETFs to be highly useful in their practices and have contributed to the rapid growth of the ETF market. Cerulli Associates reports that of the $6.5 trillion invested in ETFs at the end of 2022, approximately two-thirds are attributable to financial advisors. Further, as of 2022, over 90% of advisors reported using ETFs in their practice, up from 73% just three years earlier.¹

    Below are the ten largest ETFs by AUM as of the end of 2023. While the top ten include a bond fund and two international equity funds, the list is dominated by US equity funds. In fact, the top three ETFs all track the S&P 500 and represent well over $1 trillion in AUM.

     

     

    ¹ Cerulli Associates. The Cerulli Report—U.S. Exchange-Traded Fund Markets 2023: Product Development Opportunities for a Maturing Structure. (n.d.). In https://www.cerulli.com/.  

    The Difference between Active ETFs and Passive ETFs

    Because there are so many different types of ETFs on the market, investors have options for what types of ETFs may best complement an existing asset allocation, exposure need, or hedge. 

    Using broad strokes, ETFs generally fall into two categories. When the ETF industry started, the vast majority were passive funds tracking established, third-party indices such as the S&P 500. As of the end of 2022, the majority of ETFs (59%)² still applied this methodology. A small but growing minority (4%) utilize an active strategy.

    Passive ETFs are most commonly used among advisors as an easy, inexpensive and tax efficient way to implement strategic asset allocations in portfolio construction. ETFs are available that track a wide array of asset classes. Many of the most popular asset classes can be had for expense ratios below 10 bps per year, many even below 5 bps per year. For advisors trying to create a core portfolio, passive ETFs can be an easy, cost-effective tool. Passive ETFs can also be used to quickly implement a tactical asset allocation, like trying to shift from Large Cap stocks to Small Cap stocks for a brief period of time.

    Active ETFs have historically been very limited in number, due largely to fund managers’ hesitancy to fully disclose their holdings. However, we have seen this trend begin to shift. In most ways, active ETFs are simply active mutual funds in an ETF wrapper. They offer investors access to well-resourced money managers with the advantages that ETFs offer like liquidity throughout the day, potential tax efficiency, and, with some custodians, commission free trades. Expense ratios for active ETFs are almost always higher than for passive ETF, but usually comparable to the least expensive institutional share classes of mutual funds.

    There is a group of ETFs that don’t perfectly fit either category, but rather lie somewhere between purely passive and purely active. ETFs that tout themselves as “Smart Beta” or “Thematic” usually fall into this territory. Like passive ETFs, these ETFs track an index. However, the indices they track are usually custom designed to represent a very specific investment idea or theme. The fund company usually implements its intellectual capital through creation of a specialized index which the ETF then passively tracks. Because of the additional intellectual capital involved, these types of ETFs usually have expense ratios higher than those of pure passive ETFs. But, due to their lower ongoing operating costs, their expenses are typically lower than the expense ratios of pure active ETFs. It is important for investors to understand that most ETFs in this category are more concentrated and may have lower liquidity than pure passive ETFs that track broad market indices.

    Smart Beta” funds try to capture market factors that research has shown have historically added alpha over time. Smart beta factors include Momentum, Value, Quality and Low Volatility. “Thematic ETFs” focus on a specific theme, trend, or sector, such as technology, healthcare, innovation, cannabis, or even space travel. For investors with beliefs or investment strategies that align, these ETFs provide a useful tool.

    How are ETFs Traded?

    Exchange Traded Funds are characterized as being liquid, similar to shares of most stocks. They can be bought and sold any time during the trading day and they’re priced throughout the day, giving investors more accurate pricing information than mutual funds.

    Investors in mutual funds buy and sell their shares directly with the mutual fund. ETFs, on the other hand, only sell their shares to large market makers called Authorized Participants (APs). These APs then buy and sell the ETF shares to investors in the marketplace. This seemingly obscure operational detail is very important to understanding many of the benefits that ETFs offer over mutual funds.

    Because ETF investors purchase and sell ETF shares through the secondary market on exchanges, instead of directly with the fund company, ETF trading is much like purchasing or selling a share of stock. ETF shares can be bought or sold at any time during the trading day. As the value of the ETF’s underlying holdings shift throughout the day, the market price of the ETF will change. This means that two investors that buy the same ETF at different times on the same day can pay different prices. Unlike mutual fund investors who must wait for the price to be determined at the end of the day, ETF investors know within moments how much they paid when they bought shares and how much they received when they sold shares.

    Transactions in ETF shares may involve the payment of a brokerage commission. However, many brokers now execute trades in ETFs without charging a commission.

    All transactions in ETF shares involve a bid/ask spread. If you are selling ETF shares, you will receive the “bid” price for those shares. If you are purchasing ETF shares, you will pay the “ask” price for those shares. The difference is the bid/ask spread. The bid/ask spread compensates the market maker who facilitates the transaction. ETFs that have low liquidity for their shares or portfolio holdings tend to have larger spreads than those with high liquidity.

    What Expenses are Associated with the Use of ETFs?

    Operating expenses can impact investment returns. Be sure to evaluate the expense ratio for any Exchange Traded Fund that you’re evaluating.

    All professionally managed funds, including both mutual funds and ETFs, incur operating expenses. These costs are ultimately reflected in the internal expenses charged to investors in those funds. These operating expenses are usually reported as the fund’s expense ratio. The expense ratio is the total expenses of the fund divided by the total assets of the fund. For every 0.01% of expense ratio, investors will pay $100 per year for every $1 million invested. A lower expense ratio means less drag on portfolio returns over time.

    ETFs have operating expenses that are generally lower than those of mutual funds because ETFs have less client servicing and recordkeeping obligations than mutual funds have.

    Are There Transparency Benefits to ETFs?

    Relative to Mutual Funds, Exchange Traded Funds offer greater visibility into pricing and allocation.

    For many investors, it is important to know which securities or other assets are held by the funds they own. There is greater transparency into the holdings of an ETF than into the holdings of a mutual fund. Most passive ETFs report their holdings daily through their websites. Most mutual funds, on the other hand, report their holdings on a monthly or quarterly basis.

    What Tax Efficiency May ETFs Have?

    Consult with a qualified professional about your specific tax situation, but this is a general overview.

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    Exchange Traded Funds tend to be more tax-efficient compared to mutual funds.

    Mutual funds are required to pass on their realized capital gains to their shareholders every year. So, mutual fund shareholders often pay taxes on capital gains distributions annually even though they continue to hold their shares.

    Most ETFs, however, can avoid generating any capital gains throughout the year. This is because ETFs, unlike mutual funds, can—and frequently do—swap their holdings into and out of the fund on an in-kind basis rather than selling them and realizing a gain.

    As a result, ETF shareholders usually only pay capital gains when they sell their shares.

    Do Most Investment Advisors Use ETFs?

    A majority of investment advisors – over 90% according to Cerulli Associates – utilize Exchange Traded Funds in the portfolios.

    As mentioned earlier, Cerulli Associates reports that 90.6% of financial advisors utilize ETFs in their practice. Advisors reported allocating about 21% of portfolio assets to ETFs, with an expectation of increasing that to 24% by 2025.

    These advisors are largely using ETFs to create, or modify, asset allocations in model portfolios. Many advisors use ETFs to establish a diversified core holding while also utilizing ETFs to implement sector-specific exposures or tactical positioning.

    Who Regulates ETFs?

    ETFs have been a part of U.S. markets for more than 40 years, and they remain some of the most highly regulated products, subject to multiple and sometimes overlapping statutory schemes.

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    Exchange Traded Funds are regulated by the Securities and Exchange Commission (SEC). The majority of ETFs are structured as open-end investment companies under the 1940 Investment Act, like mutual funds.

    Some ETFs, primarily those investing in commodities, currencies, and futures—have different structures and are subject to different regulatory requirements.

    Investment advisors should apply discretion and utilize proven methods of due diligence to ensure that any ETF or investment is appropriate for any investor or portfolio.

     

    The information contained herein does not constitute investment advice or a solicitation to buy or sell any security, investment or product. You should not construe any of this information to be legal, tax, investment, financial, or other advice. This article is for dissemination of general information only. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results.

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