ETFs were on a roll even before the fiduciary rule took effect this year. Now they could see a bump up in demand as more advisers focus on reducing costs for investors.
Exchange-traded funds are cousins to regular mutual funds but offer more trading flexibility and other potential benefits. They’re popular among relatively affluent investors and people comfortable with risk. Stock portfolios dominate among ETFs, even more so than with mutual funds.
Both ETFs and mutual funds are regulated investment companies that hold pools of stocks, bonds or other assets. The regulations include those ensuring liquidity and transparency, prohibiting certain types of transactions and so on.
Like mutual funds, ETFs invest in all sorts of things — American and foreign stocks, specific industry sectors, high-dividend companies, bonds, commodities and more. “There is an ETF offering exposure to virtually every fine slice of every asset class, every strategy and every theme under the sun,” wrote Ben Johnson, an ETF research director at Morningstar, in a commentary.
In a July survey of more than 900 active investors conducted by E*Trade, respondents expressed the most interest in ETFs that track U.S. stock-market indexes such as the Standard & Poor’s 500. ETFs owning high-dividend stocks were second-most popular, followed by those that hold companies in specific sectors such as technology, finance and energy. Respondents were less interested in bond, foreign-stock or currency ETFs or those that leverage their holdings in an attempt to boost returns.
ETFs’ transparency, adaptability lauded
Alan Rosenfield of Harmony Asset Management in Scottsdale likes the transparency of ETFs — portfolio holdings typically are disclosed on fund websites daily — as well as the ability to round out a portfolio. “They’re good for plugging gaps in a portfolio, especially in areas where you lack expertise — whether in biotech, oil, banks or whatever — and don’t want to buy individual stocks,” he said. As an example, Rosenfield said he’s currently using an ETF to bet against the price of oil.
One key difference between regular funds and ETFs is in the way investors buy and sell. ETF shares trade at various prices throughout the day. They also can be sold short or bought on margin using borrowed money, like regular stocks. They are traded like stocks through brokerages. Mutual funds, by contrast, are sold through various channels and priced just once a day, meaning you’ll get the end-of session price whether you place your order in the morning or afternoon.
One caveat Rosenfield cites is the potential for EFT shares to trade with a lot of volatility as big traders could push prices up or down. Such volatility is usually short term in nature, “but it might come exactly when you want to get out,” he said.
ETFs tend to charge lower expenses than mutual funds, reflecting the fact most are passive portfolios that merely try to match the performance of various stock or bond indexes, eliminating the research costs and other expenses that go with active management.
They also tend to be more tax-efficient because ETFs hang onto their stock and bond holdings for extended periods, triggering fewer portfolio profits that get passed along to shareholders as capital-gain distributions. “Less buying and selling results in fewer taxable events — it’s really that straightforward,” noted Johnson at Morningstar. Mutual funds are much more likely to make taxable distributions. (Investors still face taxes when selling their own shares at a profit — whether in an ETF, mutual fund or individual stock.)
Low-cost ETFs an attractive recommendation
Cost reduction is a primary aim of the fiduciary-standard rules approved by the Labor Department this year. More advisers now must put client interests first and avoid conflicts of interest. It thus can help to recommend low-cost ETFs.
Many investors already have gravitated to funds that keep expenses down. According to Morningstar, the 100 largest ETFs, which account for 74 percent of all assets, charge average expenses of just 0.22 percent a year, or $2.20 for each $1,000 invested. Expenses for the other 1,700-plus ETFs average 0.55 percent.
The typical mutual fund charges 0.68 percent, reports the Investment Company Institute, though these costs have been in a long-term downward trend — the typical mutual fund charged 0.91 percent a decade ago.
Some media reports estimate ETF assets might jump by $1 trillion to $1.5 trillion because of the new fiduciary-standard rules. That’s hard to say, but they have been growing steadily. The nation had 1,646 ETFs worth a combined $2.2 trillion as of May, according to the Investment Company Institute, a trade group for both mutual funds and ETFs. That was up from $2.1 trillion spread among 1,465 funds a year earlier.
Mutual funds remain much larger, with $15.9 trillion in assets as of May, but they’ve been around a lot longer, too. ETFs debuted in the U.S. in the early 1990s.
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ETFs appeal to risk-tolerant investors
People who buy exchange-traded funds tend to be more affluent than mutual fund investors and are generally willing to take larger risks. Here are some comparisons, according to research from the Investment Company Institute:
- ETF buyers report an average household income of $110,000 and average household net worth of $375,000. Some 53 percent of these investors describe themselves as willing to accept above-average or substantially more risk in hopes of earning higher returns.
- Mutual fund buyers report an average household income of $87,500 and average household net worth of $200,000. Only 31 percent describe themselves as willing to accept above-average or substantially more risk in hopes of earning higher returns.
Note: Net worth figures exclude households’ primary residence.