Mike Hemingway, Portfolio Manager, Provides Us With “ETFs 101”.
What are ETFs?
Exchange Traded Funds. They are a basket of securities that could hold anywhere from 50 to a couple thousand securities in one place. They are like mutual funds, but as their name states, they are traded on exchanges during the day; mutual funds are not.
Who are they for?
ETFs are really for everyone. Unlike mutual funds, ETFs typically do not make capital gains distributions. For a mutual fund, if the manager sells stocks in the fund during the year at a gain, that gain is taxable. ETFs, for the most part, don’t do that. So for a taxable account, they are much more efficient. They provide great diversification and at a very low expense. Financial companies that create and manage ETFs earn money in what is called the expense ratio, and most ETFs have very low expense ratios. As a result, ETFs really are an investment for every class of investor at every part of their investment life. We use ETFs for almost all our clients. The allocation of ETFs across different asset classes for each client depends on the client’s investment objective: aggressive, conservative, or somewhere in between. ETFs provide us with the flexibility to meet each individual investor’s goals and needs.
How many ETFs are out there now?
There are around three thousand, and more are being introduced every day. They are probably the fastest growing investment product in the market today. Because they contain not just one security, but a lot, they are a great way to increase diversification and reduce the risk of putting all your eggs in one basket. We look at ETFs that cover specific asset classes like large cap US stocks or emerging markets stocks, like China and Southeast Asia. ETFs exist in the fixed income sector – bonds – as well, and we look at those in terms of duration (average maturity dates) and credit risk in both the corporate and government bond markets.
What are the risks/downsides of ETFs if any?
Like any investment, there is always the risk of market declines. There is a perception that in volatile markets ETFs may not provide liquidity. Investors are concerned that prices may drop precipitously before they can sell them; that is especially true in fixed income. However, studies have shown that ETFs hold their value even in the most volatile markets.
What is your one-sentence piece of advice about ETFs?
We maintain a list of about 70 ETFs that we have vetted for performance, size, expense ratio, etc. that we use in our client portfolios. When we look at them, the one sentence is, “We want large, established ETFs with a good track record and a low expense ratio.” In other words, we believe we can steer clients towards high performing, stable ETFs that can meet each investor’s needs.