Introduction to ETFs
Before we dive in to discover the top ETFs, let’s make a brief review of what ETFs are and what makes them an interesting investment.
What Are ETFs?
An Exchange-Traded Fund (ETF) is an investment fund that tracks an index, specific asset or basket of assets to which it is pegged. ETFs are bought and sold throughout the day like securities on the stock exchange.
ETFs cover many areas of the market including stock indexes, stock market sectors, commodities, currencies, bonds and even instruments that track the volatility of the stock market.
In some ways, ETFs might appear comparable to mutual funds, in that both involve a pool of assets. But these two types of funds actually operate quite differently. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, the price of ETFs price fluctuates with supply and demand during the regular stock market trading session. (For more on a comparison between ETFs and mutual funds, see Mutual Funds vs. ETFs: A Comparison.)
Origins of ETFs
ETFs were originally created to track various market indexes. The first ETF was the Index Participation Shares, introduced in 1989 and aimed to track the S&P 500. Toronto Index Participation Shares (TIPS) was introduced in Canada in 1990 by the Toronto stock exchange to track an index of major Canadian companies TSE 35 and later TSE 100.
In 1993, the SPDR S&P 500, which tracks the S&P 500 Index, was launched. It trades under the symbol SPY. SPDR has since become a juggernaut among ETFs.
Growth of the ETF Market
The popularity and variety of ETFs available has grown tremendously over the past decade. According to the Investment Company Institute (ICI), the number of ETFs has grown from 102 in 2001 to 1,194 in 2012 with total net assets of more than $1.3 trillion.
Advantages of ETFs
- Lower Costs: Annual management expenses of ETFs are typically substantially lower than those of mutual funds. ETFs are also free of “loads,” the entry and exit fees that some mutual funds charge. It is often pointed out that many mutual funds fail to beat benchmark indexes such as the S&P 500. However, the fact that ETFs are now available to inexpensively and effectively track these indexes highlights their potential appeal to investors. Why pay high fees to enter a mutual fund that may fail to beat an index such as the S&P 500 when you can buy an ETF that efficiently tracks the benchmark index with a very low management fee?
- Tax Efficiency: Due to low turnover and the way they are structured, ETFs are typically more tax efficient than comparable mutual funds.
- Diversification: ETFs allow investors to invest in a broad array of markets that they may not otherwise have had access to. For example, prior to the advent of ETFs, investors would have needed access to trade the futures markets in order to trade commodities such as gold. The ability to easily allocate assets into a diverse range of markets empowers investors to better manage their risk against adverse moves in the market.
- Versatility: ETFs are traded throughout the day in the same way as stocks, their prices fluctuating with supply and demand in the market. Investors can sell ETFs short and use all the various order types used with stocks to enter and exit the market. ETFs normally have the same commissions as stocks and can be traded on margin. Additionally, the barriers to entry are low, as an investor can purchase as little as one share of an ETF.
- Transparency: Unlike mutual funds, the holdings of an indexed ETF are readily visible, either in their prospectus or on their website, so you can always know what you own. While mutual funds are only required to disclose their portfolios on a quarterly or semiannual basis, all “actively managed” ETFs must by law disclose their full portfolios every day. Active management refers to the use of a discretionary element, where management actively decides on which assets to include in a fund.