2/5/2013 6:30 PM ET|
ETFs turn 20, remain misunderstood
Exchange-traded funds are sleeker and more streamlined than their mutual-fund cousins. But just as the sports car is not right for every driver, the ETF isn’t necessarily the best investment vehicle.
For many investors, exchange-traded funds still feel like a new investment product.
The first U.S. exchange-traded fund, the “spider” formally known as the SPDR Standard & Poor's 500 (SPY) ETF celebrated its 20th birthday this week.
But the passing of that landmark is an interesting milestone, because investors' understanding of ETFs has changed radically in the past two decades. At the same time, some common misconceptions persist.
ETFs were originally conceived as index mutual funds that trade like stocks. And that is precisely what the original spider has done over its two decades, even as its competition has taken that basic mission in many other directions.
Launched on Jan. 29, 1993, with $6.5 million in assets, the SPDR S&P 500 ETF isn't just the oldest, it's also the biggest, with more than $123 billion in assets. It's the most traded, too, with an average daily trading volume that is nearing 150 million shares.
Today, there are thousands of ETFs totaling almost $2 trillion in assets.
The advantages of ETFs are obvious: Costs are lower, the structure actually improves tax-efficiency -- which was saying something, given that traditional index mutual funds aren't the side of the business with unpleasant tax side effects -- and they can be traded moment by moment.
Misconceptions started right at the beginning, though. First, people assumed -- and still do -- that they were no longer investing in mutual funds. It's easy to find investors posting on message boards about how they "gave up on mutual funds" in favor of ETFs.
Technically, ETFs are exchange-traded mutual funds, but no one wanted the additional word in the acronym. The difference between traditional funds and ETFs is not the "mutual" part; it's the framework they're built on. In that regard, funds and ETFs are both like cars, just built on a different frames; the ETF is definitely the sleeker, more streamlined vehicle, but just as the sports car is not right for every driver, neither is the ETF.
Moreover, most investors will find a place for both in their holdings, whether by their choice or by dint of being involved in a retirement program in which the structure of traditional funds -- the ability to buy in without transaction costs and share-class options that allow employers to mitigate the expense of offering a plan -- keep them in the mix for several more decades.
Because both types of funds can coexist, and in the same portfolio, investors should avoid falling for the assumption that the ETF structure somehow makes their results better.
That might apply if you are looking at identical assets -- a traditional index fund compared with a lower-cost ETF on the same index ETF, for example -- but mutual funds of all stripes are "garbage in, garbage out" investments, meaning that an ETF built on a wonky index or in an out-of-favor sector is going to get hammered every bit as much as a traditional fund with the same trash.
If ETFs have a performance edge, it comes from lower costs, not from some inherent advantage in what goes into them.
That's important to remember as the ETF world begins to evolve toward actively managed funds, where the underlying fund will be only as good as the manager, and a bad manager will make for a bad ETF just as surely as a bad manager can now make for a bad traditional fund.
Traditional fund investors had their misconceptions, too, namely that because ETFs were built to be traded, they somehow pushed investors to trade.
Indeed, the high average daily volume of the original spider shows that the ETFs fit into trading strategies; there also are some ETFs, most notably leveraged funds, that aren't intended to be held for any length of time beyond hours.
But buy-and-hold index fund investors know that holding an ETF doesn't force them into trading; they can make their own long-term strategies more efficient simply by holding ETFs and capturing the cost savings while others trade around them.
Going forward, though, expect more ETFs that, unlike the spider, don't really serve both the pro and the do-it-yourselfer. Industry watchers say there will be one group of ETFs that covers the most granular, niche-oriented strategies -- allowing investors to focus on, say, the market in Sri Lanka or on companies that make refrigerated dairy products -- as well as trading strategies like leverage, and a different type of fund, including active management, built for the average mid- to long-range investor who simply wants to use the most cost-efficient structure.
With the 20th birthday party for the ETF now over, the hope is that investors can get off of the question of "funds or ETFs?" and onto the matter that should have mattered all along: "What kind of assets do I want, and where can I get them?"
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