What Exactly are ETFs?
An ETF (Exchange Traded Fund) is a security which tracks an index (e.g. North American Equities), a commodity (e.g. Natural Gas) or a set of assets (e.g. U.S. Short Term Bonds) like an index mutual fund, but trades on the open market. ETFs experience price alterations throughout the day as they are bought and sold. Because ETFs trade like a stock, they do not have a NAV (Net Asset Value) calculated every day like a mutual fund does.
Owning an ETF gets you diversification of an index fund and the ability to sell short, buy on margin and purchase in small quantities. In addition, the expense ratios for most ETFs are much lower than those of the average mutual fund. When buying and selling ETFs, the same commission that is paid on any regular order is being paid to a broker.
Why are ETFs Popular?
ETFs are popular for a number of reasons. Because they are created and destroyed in an algorithmic fashion and are (generally) not actively managed, they tend to have extremely low MERs (Management Expense Ratios) which means that an investor pays less to the fund manager than an equivalent mutual fund.
Because the assets that underlie an ETF are defined in advance and do not change frequently, market participants will arbitrage away differences in price between the assets and the ETF - meaning that ETFs generally track very close to their index or basket of securities.
For these reasons, passive, index-based ETFs are generally a staple for passive investors who are interested in participating in general stock market returns at the lowest possble cost.
How Exactly are ETFs Different From Mutual Funds?
ETFs, much like mutual funds, give investors the chance to pool their investments into a larger fund that can take advantage of economies of scale. They also can be redeemed or purchased at the end of every trading day, however unlike mutual funds they trade throughout the day at market-set prices. This provides for additional liquidity and price discovery.
Unlike mutual funds, the open exchange is the only place to transact in ETFs - ETF fund managers do not engage in direct selling of shares to (or purchase of shares from) individual retail investors. ETF sponsors make contractual agreements with financial institutions / large broker-dealers known as Authorized Participants who transact in very large blocks with the ETF sponsor and make the market on the stock exchange.
Mutual funds are priced at the end of each day at their Net Asset Value, and buy/sell orders are matched against each other in order to settle funds. Any additional shortfall is covered by selling assets on the open market. ETFs will fluctuate in value throughout the day, however will not venture far from the value of their underlying securities (due to arbitrage).
Many mutual funds depend on a professional adviser who has active involvement in the management of investments on behalf of others, and therefore attracts a fee. The expectation is that active management can take advantage of market trends or informational differences to “beat” the whole market return.
There exist passively managed mutual funds which are harder to distinguish from ETFs. The MERs are often very similar in that case due to the low cost operating structure of the fund.
Why Does RetirementPlan.io Use ETFs?
We strongly believe that passive, low-cost investments are the key for individuals planning their retirement. RetirementPlan.io helps you build a well-diversified, low-cost portfolio based on ETFs that won't cost you an arm and a leg to hold over time.
According to Nobel Prize winning economist William Sharpe:
After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.
Unless you get lucky with your actively managed mutual fund manager, you are better off keeping costs low and moving with the market.