Over the past decade, exchange-traded funds (ETFs) have become popular because of their advantages over mutual funds. Now, a new breed of ETF is seeking to mount a greater challenge to mutual funds.
Like a mutual fund, an ETF is a pooled investment vehicle that tracks an index, commodity or group of assets. But unlike mutual fund shares, shares of ETFs are traded on an exchange throughout the day at a market-determined price. So like stocks, ETFs register price changes throughout the day as sellers offer these investments for sale and buyers bid on them.
Most ETFs are based on some kind of stock index. An ETF affords investors the asset diversification of the particular index that it tracks. For example, the Spider (SPY) ETF gives investors the diversification of the S&P 500 index.
This is an example of ETFs in their passive form. In recent years, ETFs have broadened their market territory as some investment companies have begun offering them in active form. Investment managers trade them with the goal of increasing value for investors based upon specific investment objectives. These investment managers trade ETFs to execute a strategy, much as active mutual fund managers do with stocks. Strategies include growth, investing long, investing short and domestic and international securities.
Active ETFs are not only often less expensive than mutual funds in terms of fees and expenses but also hold appeal for investors who don't have enough money to qualify for the minimum investment levels required by managers of separately managed stock portfolios.
Like regular ETFs, the active variety has distinct advantages over mutual funds, including:
• Lower costs. Fees and expenses for active ETFs are slightly higher than those of their passive counterparts, but far lower than those of actively managed mutual funds. The average active ETF charges a little over .7 percent annually, compared with about 1.4 percent for the average mutual fund.
• Greater flexibility. You can sell an ETF during the trading day just as you can a stock. But with a typical mutual fund, you buy from and sell to an investment company, and the value of shares in the fund is calculated at the end of each trading day. This isn't the case with ETFs, which allow investors to sell short and buy on margin.
• Potentially greater tax efficiency. Shareholder activity and portfolio turnover doesn't affect ETFs to the same extent that it does with mutual funds, where investors can end up losing money but paying taxes on earlier gains enjoyed by others. This can result in a substantial difference in after-tax returns.
• Transparency. Active ETFs publish their holdings daily, so you can see exactly what stocks underlie them. This can benefit shareholders, especially during turbulent times. For example, if you held an ETF during the market meltdown of 2008, you might have noticed just how much exposure you had to shares of now-departed Lehman Brothers – and sold the ETF. By contrast, mutual funds only report holdings on a quarterly basis, usually with a 30-day lag.
Yet the transparency of ETF holdings can be a double-edged sword. The downside of the daily disclosures is that savvy investors will see what shares active ETF managers are acquiring, and then buy these same stocks, increasing prices that managers must pay as they continue to accumulate shares.