What are Exchange-Traded Funds? An exchange-traded fund (ETF) is an investment company that typically has an investment objective of striving to achieve a similar return as a particular market index. The ETF will invest in either all or a representative sample of the securities included in the index it is seeking to imitate. Like closed-end funds, ETFs can be traded on a secondary market and thus have a market price that may be higher or lower than their net asset value (NAV). The net asset value is the total value of a fund’s assets less the liabilities. If the ETF shares trade at a price above their NAV, they are said to be trading at a premium. Conversely, if they are trading at a price below their NAV, they are said to be trading at a discount. For example, if the net asset value of the fund is $50 and the fund is selling at $55 on the exchange, the fund is said to be trading at 10% premium to the NAV. If the fund is selling at $45, it is said to be trading at a 10% discount to the NAV. Typically, ETFs track stock indexes and are offered through a variety of well-known companies, including Standard & Poor’s, Dow Jones, Vanguard, Merrill Lynch, and Barclays. The oldest and biggest ETF tracks the S&P 500 index. It’s called SPDRs, short for Standard & Poor's Depository Receipts. It began trading on the American Stock Exchange under the symbol SPY. Since exchange-traded funds track specific indexes, their price fluctuates with the performance of the index. The companies and ETFs discussed herein are for illustrative purpose only and not a recommendation for the purchase of those specific securities.
ETFs Are a Fast-Growing Investment Vehicle Innovative offerings in equities, fixed income, and emerging markets have made ETFs one the fastest-growing investment vehicles in the financial industry. ETFs are a popular investment choice among both active and passive investors because of their flexibility to trade like a stock and instant diversification in the form of an index fund. Keep in mind that diversification does not eliminate the risk of investment losses. The U.S. market accounts for the largest volume of ETFs in the world. The image illustrates the increase in the number and total assets of exchange-traded funds since 1995. Due to an increasing demand from investors in recent years ETF assets have nearly doubled every two years. The first ETF called Spiders was based on the S&P 500 index. This investment was launched in 1993 followed by 19 ETFs traded in 1996. In 2009, the total number of ETFs rose to 797, with assets worth about $777 billion. Source: Investment Company Institute.
What Kinds of ETFs are Available in the Market? ETFs track a wide variety of market indexes, the most prominent being equity indexes. ETF funds also include fixed-income securities, commodities, and currencies. Exchange-traded funds cover both domestic and international indexes. In addition, exchange-traded funds may be based on certain characteristics such as market capitalization (small-, large- and mid-cap stocks), or investment styles like growth, value, and blend. Exchange-traded funds can be used to diversify across different sectors such as health care, technology, real estate, utilities, etc. There exist ETFs which track certain characteristics like dividend-paying stocks. For example, ETFs may track a group of securities which have a number of consecutive years of dividend growth. Another variation may be an ETF that tracks an index which consists of the 100 highest-yielding stocks whose dividends are equal to or greater than dividends paid five years ago. Some ETFs permit shareholders to reinvest their dividends to purchase additional ETF shares. The increase in recent market interest has resulted in a large number of novel ETF options for investors. Some of the popular ETFs include the Qubes, SPDRs, sector SPDRs, MidCap SPDRs, HOLDRs, iShares, and Diamonds, all of which are passively managed and track a wide variety of sector-specific, country-specific, and broad-market indexes. DIAMONDs : The DIAMONDs tracks the Dow Jones Industrial Average. iShares : iShares are structured as open-end mutual funds. HOLDRs : HOLDRs are holding company depository receipts bought and sold in 100-share increments and focus on narrow industry groups. Spiders : The Spiders are comprised of depository receipts that track a variety of Standard & Poors' indexes. StreetTracks: StreetTracks track various indexes, including Dow Jones style-specific and global indexes, technology indexes. The ETFs discussed herein are for illustrative purposes only and not a recommendation for the purchase of securities. Keep in mind that diversification does not eliminate the risk of investment losses.
Comparison of ETFs and Index Funds Traditional index funds and ETFs typically consist of a portfolio of securities that mirrors a market index and attempts to match the returns of the index. However, they differ in certain characteristics such as ownership, pricing, management style, and costs. Ownership ETFs issue shares in large blocks (50,000 shares) typically known as creation units. These creation units are then split into individual shares and traded in a secondary market. The individual shares become available for investors to purchase. Index funds, on the other hand, can usually be purchased directly from the fund company. Pricing ETFs are traded throughout the day on an exchange, like stocks. ETFs are subject to price fluctuations and can trade at a premium or discount. Index funds are priced at the close of each business day. Investors can choose to buy or sell index funds at any time during the day, but the price of a fund is determined at the end of the day. Management style Typically, both ETFs and index funds are passively managed. Changes to the portfolio are the result of alterations in the underlying index. Costs Investors incur brokerage commissions when buying or selling ETFs. In addition to trading costs, investors may sometimes pay management fees when investing in ETFs. Index fund investors generally pay a management fee and, depending on the method of purchase or distribution, may also be required to pay commissions on trades. Source: Investment Company Institute.
Assets of ETFs and Index Funds Index funds serve as a low expense investment vehicle that matches the performance of an index. Since their introduction in 1975, index funds have seen steady growth in assets. In the past few years, exchange-traded funds have evolved as an attractive and viable alternative to index funds. The image illustrates the net assets of ETFs and index funds as of December 2009, broken down into six unique categories. ETF and index fund assets in the small- and mid-cap groups are similar. The specialty ETF category surpasses the specialty index fund category, with net assets of $94.5 billion compared to $7.9 billion for index funds. One reason attributed to such growth is the attractive investment offerings in the specialty ETF class. Large-cap and bond index funds, however, have a much higher total asset value when compared to their corresponding ETF categories. The demand for ETFs has moved alongside the growing demand for index funds. Investors have a variety of ETFs and index funds available which are spread across many broad asset classes. However, as the image conveys, the majority of assets are concentrated in the large-cap equity category. About the data Index fund asset data is from the index fund category in Morningstar’s open-end database. ETF asset data is from the exchange-traded fund category in Morningstar’s open-end database.
Categories of ETFs In recent years, ETFs have expanded beyond traditional asset categories such as stocks and bonds to include commodities and currencies. Further, growing interest in ETFs has sparked the addition of actively-managed ETFs that implement different investment strategies. Traditional ETFs: Traditional ETFs typically track indexes based on market capitalization. These traditional exchange-traded funds include both the equity and fixed-income categories. Commodity/currency: There exist ETFs that track currencies and exploit non-correlated assets. ETFs of precious metals or commodities invest in companies that mine for gold and silver. Oil funds include ETFs tracking companies that find and produce natural resources. Fundamentally weighted: Fundamentally weighted ETFs are funds tied to indexes that weight stocks according to certain factors like company dividends, fundamental growth, stock valuation, timeliness, and risk. Some ETFs are based on income focused funds. ETFs may be based on fundamentally weighted dividend indexes rather than traditional indexes that are weighted by market capitalization. ETFs may also be based on cash dividends paid by companies or companies committed to growing dividends over time. Quantitatively enhanced: Quantitatively enhanced ETFs use rules based on quantitative analysis to choose underlying securities in an index. The goal of quantitatively enhanced ETFs is to identify stocks that may have more potential than similar stocks for capital appreciation. Leveraged/short: Some ETFs allow investors to profit from a market slump. There are others that pursue leveraged and inverse strategies. They fall into three strategy groupings: "Dynamic," which aims to double an index's returns; "Inverse," which aims to generate the opposite return of an index; and "Dynamic Inverse," which aims to generate twice an index's opposite returns.
ETF Market Coverage The first ETF, introduced in 1993, was a domestic equity based fund. In the past few years, however, exchange-traded funds have received much attention as net assets increased at a rapid pace. This trend spurred investor interest and as a result brought about more funds with greater variety. Over the past few years, the ETF market has grown to include funds that invest in international equities. A more recent development has been the introduction of specialty ETFs and funds that track specialized indexes. In addition, bond and commodity ETFs have become new market entrants. The image illustrates the worldwide market coverage of exchange-traded funds in terms of where assets are located. ETFs are distributed among different asset classes such as equities, bonds and specialty groups. The most prominent ETF asset class is domestic equities, accounting for about 43% of ETF assets in the market. Domestic equity ETFs are followed by international ETFs, which account for 28% of ETF assets in the market. Fixed-income ETFs are a fairly new offering and represent only 15% of all ETF assets in the market. Specialty ETFs are typically sector based and constitute about 14% of all ETFs available. About the data Asset data is from the exchange-traded fund category in Morningstar’s open-end database. Domestic ETFs are represented by domestic large, mid, and small stock categories, international ETFs by the foreign category, fixed income ETFs by the fixed-income category, and specialty ETFs by the specialty category.
Expense Ratios of Large-Caps: ETFs, Index Funds and Active Funds ETFs normally have lower expense ratios when compared to traditional mutual funds. The lower costs are typically attributed to lower premiums, unlike actively-managed funds, which charge higher premiums for fund manager expertise in picking investments. The image illustrates the distribution of expense ratios for large-cap ETFs, index funds and actively-managed mutual funds. For actively-managed funds, it appears that expense ratios are high on average, with many funds even exceeding 1.5%. Expense ratios for large-cap index funds, however, vary widely from 0.1% to over 1.5%. The average active fund investing in large-cap stocks carries an expense ratio of 1.26% of the investor’s holdings, and the average index fund, 0.72%. Expense ratios for large-cap ETFs appear to be lower on average, and are typically concentrated between 0.1% and 0.8%. The average expense ratio for large-cap ETFs is about 0.44%. The difference in costs between ETFs and traditional funds may not seem substantial, but these costs add up over time. It is important that investors evaluate their investment goals when selecting a fund. About the data Expense ratio data is from Morningstar’s open-end database. ETF and index fund expense ratios are from the domestic large-cap ETF and domestic large-cap index fund categories, respectively. It is important to note that the data herein does not account for brokerage/transaction costs, only expense ratios.
Average Turnover Ratio Exchange-traded funds (ETFs) have typically had lower turnover ratios than index and actively-managed funds, resulting in lower tax liabilities for investors. This image illustrates the average turnover ratio of large-cap ETFs, index funds and actively-managed funds. The average turnover ratios for large-cap ETFs, index funds and active funds were 50%, 55% and 92%, respectively, as of December 2009. Turnover is the measure of how many of a fund’s holdings have been sold and replaced. ETFs have had a lower turnover ratio when compared to index and active funds. The benefit of a lower turnover ratio translates into a lower tax liability. A sale may result in the realization of a capital gain that must be distributed to the shareholder. The reason ETFs and index funds have lower turnover than actively-managed funds is that index portfolios track the holdings of an index, such as the S&P 500, and therefore only buy and sell securities in order to stay consistent with the index. In contrast, managers of actively-managed funds seek to enhance performance by buying and selling securities as often as they feel necessary to accomplish their fund’s objective. The goal of an actively-managed fund is to implement strategies such as market timing, asset allocation, and stock picking to produce returns superior to an appropriate benchmark. Turnover ratio for ETFs is an average of all large-cap ETFs listed in the Morningstar open-end database. Turnover ratio for index funds is an average of all large-cap index funds listed in the Morningstar open-end database. Turnover ratio for active funds is an average of all large-cap actively-managed funds in the Morningstar open-end database. Funds with turnover ratios exceeding 1,000% were excluded from this analysis. Source: Morningstar, Inc.
Active Versus Passive Fund Strategies Mutual fund strategies can be classified into two categories: actively-managed (active), and passively-managed (passive). An active fund is a fund whose manager takes action by evaluating investments, buying securities that are expected to perform well in the future and selling the ones in the portfolio that are expected to perform poorly. A passive fund is a fund whose manager only attempts to replicate the underlying holdings of a benchmark (index) and does not add or remove from these holdings (this type of strategy is commonly referred to as “buy-and-hold”). Passive strategies are usually associated with index funds and ETFs. Active funds generally have higher fees than passive funds; whether these higher fees are justified through better performance is a matter of ongoing debate. The image presents the percentage of active funds in the nine style-box categories that have outperformed their respective Morningstar indexes for the 1-year, 3-year, and 5-year periods ending December 30, 2009. For the 1-year period, a significant percentage of outperforming funds could be found in the large-value and large-core categories. In all of the other categories, more than half of the active funds performed worse than their benchmarks. For the 3-year period, a high percentage of active funds outperforming their benchmarks can be found in the large- and mid-value categories. Again, in all of the other categories, more than half of the active funds performed worse than their respective style indexes. On a 5-year basis, again, only two categories (large growth and large value) had more active managers outperforming the index than underperforming it. There are many studies that have tried to establish the advantages of one approach over the other (active versus passive). In most cases, active managers’ attempts at beating the market end up falling short. Some extraordinarily-gifted active managers out there can repeatedly produce above-market returns but, as the image illustrates, most do not. Keep in mind that an investment cannot be made directly in an index, and past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. The investment return and principal value of mutual funds will fluctuate and shares, when sold, may be worth more or less than their original cost. Investors should read the prospectus and consider this information carefully before investing or sending money. Holding a portfolio of securities for the long term does not ensure a profitable outcome and investing in securities always involves risk of loss. Mutual funds are sold by prospectus, which can be obtained from your financial professional or the company and which contains complete information, including investment objectives, risks, charges and expenses. About the data Data includes the oldest share class for all U.S. diversified mutual funds with at least a one-year history in Morningstar’s database. As of June 30, 2009, there were 2,049 eligible funds. Morningstar classifies funds into style categories based on the average style score (using the same 10-factor methodology as underlying benchmarks) of all available portfolio holdings.
Risk Factors of ETFs Investors in exchange-traded funds may face many different forms of risk depending on the kinds of ETF investments they choose. While the benefits of diversification from ETFs may lower the downside risk of a single security, it is important to understand that the value of an ETF may decline due to factors affecting the underlying index. For example, economic factors such as recession may decrease the value of the underlying index. Market risk Stocks tracked by an ETF are subject to the same risks as traditional equities. The market prices for ETFs fluctuate in the same manner as stocks on a daily basis. These fluctuations may be a result of economic conditions, investor sentiment, or security specific factors. Interest rate risk Fixed-income ETFs are subject to fluctuations in the interest-rate environment. The prices of bond securities tend to rise with the decline of interest rates and vice versa. ETFs that track fixed-income securities are exposed to such changes in interest rates. Typically, there is greater price volatility associated with bonds with a longer maturity. Currency risk International ETFs are subject to risk of capital loss due to currency fluctuations and a country’s economic factors. Currency exchange can affect the returns of a foreign security because foreign exchange rates constantly fluctuate with changes in the supply and demand of each country’s currency. Thus, returns achieved by local investors are often quite different from the returns that U.S. investors achieve—even though both may be investing in the same security. Credit risk Credit risk arises from the uncertainty in a counterparty's ability to meet its obligations. For example, the value and ability of ETF funds to pay dividends may be compromised if the issuer is unable to make payments of principal and interest.
Pros and Cons of ETFs Passive diversification: By buying a single unit of an ETF, investors can get exposure to all the securities that make up the index—for example, the S&P 500. ETFs also reflect the performance of different sectors in the market, which can enhance the diversification benefits of investor portfolios. Transparency of price: Since ETFs trade like stocks, their prices can change every minute and new prices are available to investors at all times during trading hours. By contrast, mutual funds are priced once a day, after the market's close, and investors can buy or sell only at the closing price. Tax efficiency: When mutual funds realize a capital gain, they are obligated to distribute those gains to investors on an annual basis, which is a taxable event for non-retirement accounts. ETFs usually realize capital gains when changes are made to the benchmarks (index funds) they track. Index portfolios generally have lower turnover ratios than actively managed funds, which makes ETFs ideal for taxable accounts. ETFs may also realize capital gains if the share price of the ETF rises. The share price of the ETF is set as a percentage of the share price of the index that the ETF is tracking. Protection against cash drag: Cash drag is the return lost when an open-end fund manager has to keep cash on hand or sell assets to redeem shares. Long-term investors are disadvantaged most by cash drag. ETFs don't need to hold cash in anticipation of redemptions. This means that ETFs save trading costs and minimize the cash drag effect, which occurs when funds are required to hold cash and therefore are not able to maximize the total return of the fund. Cost advantages: Unlike many fully managed mutual funds, there are no front-end or deferred sales charges with ETFs, which are bought and sold like stocks. On the exchange, the investor pays the spread between the buying and selling price, which is generally lower cost than the front-end load and transaction fees of mutual funds. Brokerage costs: ETFs incur brokerage commissions which reduce total returns. ETFs are bought and sold through a broker which typically results in brokerage costs every time a buy or sell transaction occurs. Brokerage costs incurred may be a significant percentage of the investment for smaller transactions. Market pricing: Since ETFs trade like stocks, their price is determined by market supply and demand as opposed to the underlying net asset value. The net asset value determines the value at which mutual funds are purchased or sold. As a result, exchange-traded funds may trade at a premium or discount to their net asset value. Mutual funds typically calculate net asset value once every business day. Relatively new: Some ETFs, for example fixed-income ETFs, are relatively new and have been around for less than five years. Their relative newness in the market may pose a few drawbacks in terms of historical data that may be available. Limited selection: The limited availability of ETFs in certain asset categories such as fixed income can be a disadvantage for investors seeking to diversify their portfolios with different fixed income ETFs. `
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