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What Exactly is an ETF?

ETF’s are big topic of conversation at Gebhardt Group.  Clients and friends are asking us quite often to help them better understand what they really are.  I am amazed at how many people ask that question.  Amazed because so many of the people asking me that question already own them inside of their 401k, whether they realize it or not.

ETF is an acronym that stands for “exchange-traded fund.”  ETF’s have been around since the early 1990’s, but really did not gain much popularity in 401k plans until about 10 years ago.  Although ETF’s have begun to gain popularity, the ETF market still pales in comparison to the mutual fund market; about $1.3 trillion in ETF’s versus almost $15 trillion in mutual funds.

To truly understand ETF’s, let’s take a look at history and see the product evolution that lead to their creation.  ETF’s were born from the progression of actively managed mutual funds and passively managed index funds.  Let’s look at both of these product types first, so that we may better understand the distinction of ETF’s.

Actively Managed Mutual Funds

A mutual fund is a big basket of individual investments (like stocks such as IBM, Proctor & Gamble, Apple, Coca-Cola, etc.). Every day, the fund issues new shares to those who want to own a “slice”.  It is the simplest way for an investor to diversify their money with a small investment amount (most fund companies let you purchase shares for as little as $2,000).  The best way to understand this structure and its benefits is to think of an extra-large pizza pie with a handful of toppings; pepperoni, sausage, olives, mushrooms, onions, and peppers (sort of makes you hungry, right?).  You cut the pizza into eight slices and share it with a few friends.  Each slice has a sampling of all of the selected toppings on it.  The best part of having multiple toppings is that if one topping is bad, say the olives, one can just pick them off without ruining the whole pizza slice. 

Mutual funds work much the same way.  If all of your retirement money was invested in one individual stock, and that stock became worthless, you would be in big trouble.  But if your retirement money was invested inside of a mutual fund, where you had a “slice” that contained samplings, or fractional shares of hundreds of stocks, you would be much less concerned if one “went bad”. 

So who manages the mutual fund and what are they trying to accomplish? 

Mutual funds rely on a portfolio manager, or a team of portfolio managers to actively manage investments on behalf of others, usually for a hefty fee.  According to Morningstar, the average annual fee charged for a mutual fund is 0.90%.  This is also called an expense ratio.  In addition to the expense ratio, it can cost an additional 1.44% per year in transaction costs, which are the costs portfolio managers incur for buying and selling stocks inside their funds.  These costs can be more difficult to determine on a fund by fund basis because fund companies are not required to publish these additional expenses in their fund prospectus.   

In exchange for paying upwards of 2.5% to 3% per year in total fees, portfolio managers hope that their active management can take advantages of mispriced stocks or trends in the market to “beat” the overall market return.  Unfortunately for most portfolio managers and their fund investors, history has proven that hope has not been a successful strategy, as the majority of fund managers have failed to outperform their benchmarks.

Passively Managed Index Mutual Funds

Imagine the pizza pie we used to describe an actively managed mutual fund.  However instead of a handful of toppings on your pizza pie, imagine every topping ever created; 500 to be exact.  Each slice would have a small sampling of 500 different toppings.  I know what you’re thinking; it would almost be impossible to distinguish the taste of one topping from another.  But that was the belief of John Bogle, founder of Vanguard Funds. 

Mr. Bogle launched the first index mutual fund in 1976 based on his belief that it was nearly impossible for any manager to beat the markets by actively trading a handful of stocks.  He also believed it was in an investor’s best interest to stay fully invested in the entire market at all times, riding it up and down for a long period of time.

Bogle’s first index fund tracked the Standard and Poors 500 Index, also known as the S&P 500. It was called the Vanguard 500 (VFINX).  By owning all 500 stocks of the S&P 500, Bogle was able to promise investors that his fund would keep up with the broad index of stocks.  Since his fund was not actively managed, it costs very little to operate, which translated to a very low cost for investors.

Wall Street and the financial advisory community were not fans of Mr. Bogle and his new invention.  They quickly slandered the Vanguard 500 Fund by referring to it as “Bogle’s Folly”.  It was the belief of Wall Street and most financial advisors that their primary job was to beat the broad market and that Bogle’s invention was a joke.  Unfortunately the joke was on Wall Street and their financial advisors as so few actually were actually able to beat their benchmarks and Bogle’s Vanguard 500 Fund, especially once you added their 2.5%-3% each year in fees.

Index funds have gained in popularity over the past three decades.  Today there are hundreds of index funds, each tracking their own benchmark and typically at tiny fraction of the cost of actively managed mutual funds.  They are some of the most popular fund offerings inside company-sponsored 401k plans.

What is an ETF?

An ETF is a type of index fund.  It is similar to an index fund in that it has the same goal of an index fund: To provide investors with a low cost product that offers broad market returns. There are two important differences, however.

First, index funds are like traditional mutual funds in that they are only priced once per day, at the close of the market session.  The average price of all the underlying securities are calculated after the market closes, and the fund company posts the net asset value per share (NAV) based on the aggregate of all of those prices.  In contrast, ETF’s are a fixed basket of securities that trade all day long on the stock market, with the basket itself behaving more like an individual stock.  The price of that basket of stocks can fluctuate all day long based on the underlying values of the holdings within the ETF.  This can give investors much greater liquidity (ability to buy or sell shares quickly and at any time the market is open) than relying on a mutual fund or index fund that only prices itself once per day after the market closes.

The second main difference is the cost of trading mutual funds and index funds, compared to the cost of trading an ETF.  Mutual Funds and Index funds often have significant transaction fees associated with buying or selling shares.  ETF’s often trade commission-free.

ETF’s Version 2.0

As ETF’s have become more popular, more and more have been designed to do more than just mimic an index fund.  Sector specific ETF’s have become quite popular, where all of the holdings inside an ETF are from one specific sector, like healthcare or technology.  Many fee-only advisors have adopted ETF’s into their practices as efficient tools to actively manage client portfolios and gain exposure to multiple sectors of the market. 

But “DIY-ers” beware.  There are risks and complexities associated with buying and selling ETF’s.  If you are a do-it-yourself investor and you want to have the flexibility of an ETF’s low trading cost and performance similar to an index fund, it’s best to use only the largest, most widely traded ETFs on the market, the ones designed to match well-known benchmarks.  The smaller sector-based ETF’s often have much less liquidity on a daily basis, as fewer shares are traded compared to the big index-based ETF’s.  Also, like mutual funds, ETF performance can vary widely from issuer to issuer, even those that seem to track the same benchmark or sector. 

ETF’s have become the next great innovation in the mutual fund/index fund universe.  They can be very efficient investment products and are showing their rise in popularity by popping up more and more inside company-sponsored 401k plans.  If you own a 401k plan and you choose to go at it alone, selecting your own ETF’s, please do your homework.  Managing an active portfolio of ETF’s in not for novice investors with a weekend hobby.  Work with a professional when at all possible. 

Help, Please!

If you can’t find a local professional willing or qualified to help you with the ETF’s in your 401k, we’d be happy to.  This is your retirement we’re talking about; let’s get it done right.  Whether your plan has actively managed mutual funds, passively managed index funds, ETF’s or all of the above, our online GPS tool can give you the turn-by-turn guidance you’ve been looking for to help with your 401k.

Matthew Grishman is a Principal & Wealth Advisor at Gebhardt Group, Inc.  Matthew has 19 years of experience guiding families, entrepreneurs, and athletes through the complexities of financial planning and living their life’s true purpose.

Important Disclosures:  CA Insurance License #0D99998.  Matthew Grishman is an Investment Advisor Representative of Gebhardt Group, Inc., a Registered Investment Advisor, and 401k Masters, LLC, a Registered Investment Advisor, as governed by the Securities and Exchange Commission. Gebhardt Group, Inc. and 401k Masters, LLC are affiliated companies.

The opinions in this piece are for informational purposes only and are not intended to provide specific advice or investment recommendations. To determine which investment(s) may be appropriate for you, consult a financial advisor prior to investing. Market performance is historical and there is no guarantee of future returns.

© Copyright 2015, Gebhardt Group, Inc.  All rights reserved. 

Reproduction or reprinting of copyright materials is strictly prohibited without express written permission from 401k Masters, LLC.

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