There are many advantages to ETFs and some of the most popular are:
- ETF typically have lower management fees as well as there are no sales load on ETFs. However, brokerage commissions do apply
- ETFs can be bought or sold at any time of the day. Conversely, mutual funds settle after the market close
- More tax efficient: Investors have better control over when they pay capital gains tax
- Trading transactions: Because they are traded like stocks, investors can place a variety of types of orders such as limit orders, stop-loss orders, and buying on margin, which are not possible with mutual funds
While superior in many respects, ETFs do have drawbacks, including:
- Trading costs: If you invest small amounts frequently, there may be lower-cost alternatives investing directly with a fund company in a no-load fund
- Illiquidity: Some thinly traded ETFs have wide bid/ask spreads, which means you’ll be buying at the high price of the spread and selling at the low price of the spread
An ETF, exchange-traded fund, is an investment that’s built like a mutual fund—investing in potentially hundreds, sometimes thousands, of individual securities—but trades on an exchange throughout the day like a stock.
An ETF is similar to a mutual fund in that it offers investors a proportionate share in a pool of stocks, bonds, and other assets. It is most commonly structured as an open-end investment company, as are mutual funds, and is governed by the same regulations. Also, like a mutual fund, an ETF is required to post the marked-to-market net asset value of its portfolio at the end of each trading day.
Any asset class that has a published index and is liquid enough to be traded daily can be made into an ETF. Bonds, real estate, commodities, currencies, and multi-asset funds are all available in an ETF format.
A broker can help facilitate a short order on an ETF. Most ETFs advertise that they can be shorted, but often there is a limit on the number of shares that are available to be sold short at any given time.
The biggest advantages of getting into ETFs versus investing in mutual funds or stocks include:
- Lower cost management fees
- Low fixed transaction costs
- Tax efficient
- Instant pricing
- Global investment menu
Nearly every type of investor will find ETFs more compelling than mutual funds.
On the other hand, some of the features which are advantages for most investors can be unattractive for certain others. Fixed transaction costs, which are low for investors buying large dollar amounts of ETFs, become relatively high for investors buying small dollar amounts at a time. Therefore, any investor buying less than $1,000 worth of ETFs at a time should consider buying a transaction-free ETF or mutual fund.
An index is a group of securities chosen to track a particular investment theme such as a market, asset class, sector, industry, or even strategy. Generally the goal is to accurately represent the risk/return profile of that theme without necessarily holding every security that might qualify.
The exact compilation of securities in an index is known as its basket, while the proportion of the index each individual security comprises is its weighting. An index’s value is a single number that, when referenced to a starting value, describes how the index has performed over time.
Indexes serve as a representation of markets, sectors, investment themes or asset classes.
Markets or even individual market sectors, such as large cap stocks, or real estate investment trusts, can be extremely large as they including hundreds and even thousands of securities. Buying up all the securities just to access one market or asset class is too expensive and time-consuming —not to mention ineffective – for most market participants.
That’s where indexes come in. An index is comprised of only the securities most relevant to its investment theme, allowing market participants to follow market trends without having to track the entire available universe of securities. Essentially, an index acts as a yardstick, capturing representative exposure to a particular market or sector.
There are thousands of available indexes tracking countless market themes or approaches, from large capitalization stocks to foreign currency markets to retail real estate.
Market participants can use indexes in a variety of ways:
- To assess a given market’s performance
- To gauge how well an active strategy is working
- To serve as the foundation for investment products, such as ETFs or mutual funds
- To evaluate a market’s risk profile or its diversification benefits
- To measure passive risk premia
In 1884, Charles Dow composed his first stock average, which contained nine railroads and two industrial companies that appeared in the Customer’s Afternoon Letter, a daily two-page financial news bulletin which was the precursor to The Wall Street Journal. On January 2, 1886, the number of stocks represented in what is now the Dow Jones Transportation Average dropped from 14 to 12, as the Central Pacific Railroad and Central Railroad of New Jersey were removed. Though comprising the same number of stocks, this index contained only one of the original twelve industrials that would eventually form Dow’s most famous index.
Most market participants and media refer to the market or markets in the US as:
- The S&P500 Index (SPX) which is a market capitalization index
- The Dow Jones Industrial Average (DJIA) which is a price weighting index
- The Nasdaq 100 (NDX) which is a market capitalization index of Nadaq-listed only companies
A benchmark ETF (exchange traded fund) is more commonly known as an index-tracking or passively managed ETF. The fund’s directive is to track the underlying benchmark which is the market for that particular asset class or strategy.
A benchmark is a standard against which the performance of a security, mutual fund or investment manager can be measured or judged. Benchmarks are created to include multiple securities representing some aspect of the total market. Broadly speaking, a benchmark is an index that serves as the measurement yardstick for a portfolio by comparing portfolio characteristics such as returns, risk, component weights and exposure to sectors, styles and other factors to the benchmark.
It is a point of reference from which measurements may be made. In investing circles, almost all benchmarks are indexes, although not all indexes are benchmarks. Active managers try to beat benchmarks while most ETFs track benchmarks.
A benchmark serves a crucial role in investing. Often a market index, a benchmark typically provides a starting point for a portfolio manager to construct a portfolio and directs how that portfolio should be managed on an ongoing basis from the perspectives of both risk and return. It also allows investors to gauge the relative performance of their portfolios.
Selecting a specific benchmark is an individual decision, but there are some minimum standards that any benchmark under consideration should meet. To be effective, a benchmark should meet most, if not all, of the following criteria:
- Unambiguous and transparent – The names and weights of securities that constitute a benchmark should be clearly defined.
- Investable – The benchmark should contain securities that an investor can purchase in the market or easily replicate.
- Priced daily – The benchmark’s return should be calculated regularly.
- Availability of historical data – Past returns of the benchmark should be available in order to gauge historical returns.
- Low turnover – There should not be high turnover in the securities in the index because it can be difficult to base portfolio allocation on an index whose makeup is constantly changing.
- Specified in advance – The benchmark should be constructed prior to the start of evaluation.
- Published risk characteristics – The benchmark provider should regularly publish detailed risk metrics of the benchmark so the investment manager can compare the actively managed portfolio risks with the passive benchmark risks.