Throughout the last 5 years with my previous firm, this was hands down the most common questions I received from clients. It’s no wonder given the massive ETF growth the industry has experienced. Today there are nearly $3 Trillion in US ETF assets alone. * The good news is, they’re quite simple.
Let’s start with the basics: ETF stands for “Exchange Traded Fund”. Like a stock, they trade on the US exchange and you can do so intraday. Remember that Mutual Funds only price at the close of each business day. Like Mutual funds, however, they offer a basket of diversified stocks or bonds wrapped in a single investment. At its most basic definition, an ETF could be thought of as a mutual fund that trades like a stock. I’d like to take it a step further to my favorite analogy. When I think of what differentiates Mutual Funds and ETFs, I can’t help but thinking about making my favorite chocolate chip cookies. To me, an ETF is similar to a recipe. If you’re not the next Betty Crocker, the likelihood is that flip over the back of the chocolate chip bag and follow the free recipe provided: 4 Cups flour, 2 Eggs, Sugar, Vanilla, pinch of salt… you know the drill. If you follow it verbatim, you get what I refer to as the standard or “benchmark” chocolate chip cookie. Taking it back to our ETF comparison, an ETF is simply looking to replicate an index or benchmark, such as the S&P 500. Their manager is responsible for tracking the S&P as close as possible so that they have nearly identical returns. Compare this to a Mutual Fund Manager whose primary investment goal may be to outperform the S&P 500. The mutual fund Portfolio Manager will likely have many of the same holdings as the ETF, but they are not required to have identical weightings to the bench nor are they required to own every company within the respective index. Instead, we pay those managers to meet with these companies, study their balance sheets & determine if they see an opportunity to invest. Ideally, their research will translate to returns better than the bench over a full investment cycle. This is no different than if you’re buying your cookie from Food Network Star, Bobby Flay. He has years of culinary expertise & isn’t going to follow a basic recipe. As a matter of fact, he’s probably going to enhance what he views as the average chocolate chip cookie by adding a rich dark chocolate, fancy walnuts, and substituting apple sauce for veggie oil. Not surprisingly, you’d probably pay a little bit more for the cookie made by the professional than your own homemade cookies. When we consider the cost of an ETF vs. MF, we have the same idea. Since less research and due diligence is required to manage an ETF, it tends to be the less expensive investment vehicle. The Mutual fund on the other hand - which offers professional management is something we might want to pay up for. As we know, cost does not always translate to under or over performance, but is an important consideration in how we balance our entire investment portfolio. While this is a simple analogy, I hope it gives you a better understanding of each investment. Please reach out to any member of the FPL family if you have questions for us.
*Source: Financial Times (https://www.ft.com/content/89c18106-3591-11e7-bce4-9023f8c0fd2e)
“The shift towards ETFs has been particularly powerful in the US, where assets stand at almost $2.8tn at the end of March, compared to the $16.9tn US mutual fund industry, according to the Investment Company Institute. A year earlier the numbers were $2.1tn and $15.7tn, respectively.”
Date of article, May 10, 2017
Exchange traded funds are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
It is not possible to invest directly in any index. The performance of an unmanaged index is not indicative of the performance of any particular investment. Past performance is no guarantee of future results
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