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The origins of ETFs' can be found in academic studies which support the idea that all managed mutual funds, over time, will under-perform an indexed fund representing a broad cross-section of the market. The fact that some funds may have outperformed the market average for 10 or 20 years does not necessarily attest to their superior performance. With some 13,000 funds in existence, the law of averages combined with luck can easily account for a handful of funds having a string of superior results. As Nassim Taleb points out in his book "Fooled By Randomness - The Hidden Role of Chance in Life and in the Markets", never under estimate the importance of luck.
ETFs are designed to give you market average results for a particular market or sector, nothing more and nothing less. They buy a basket of securities representing a cross-section of a particular market. Most important, they make very few changes to that basket of securities. The fund sponsor creates new fund shares as demand requires. Sellers can either sell their shares on the open market, or turn them in to the fund sponsor who will give him the equivalent in underlying securities.
This feature means that, unlike closed end funds, the fund will never vary much from the underlying net asset value of its holdings. Shares within the basket are only bought and sold if a new security is added or removed from the index being tracked or if a merger/acquisition makes a share disappear. Over time, such an ETF will outperform all but the most fortunate conventional/open-end funds because it has a number of factors working in its favor:
There is a minimal management fee since there is minimal intellectual input, trading and less administrative requirement (e.g. no need for shareholder accounting at the fund level.
There are no 12b-1 fees for distribution costs, advertising and trailing commissions to the selling brokers.
There is a minimum of capital gains distributions since the fund hardly trades. Hence, there are no unexpected year end tax consequences.
The typical mutual fund holds up to 5% or 10% of its assets in cash to meet share redemptions while the ETF holds virtually none. This money is not working for you.
For a long-term holder, there is no cost for the portfolio turnover so common to all conventional mutual funds, nor do you share the costs in buying and selling holdings to accommodate new investors or those who are liquidating.
Your cost basis in the fund is what you paid for your shares. You don't inherit unrealized gains and losses accumulated from prior years or prior holders and distributed to whoever holds the shares at year end. You also don't end up with taxable gains in years when your fund has declined in value.
Shares can be bought and sold anytime of the day during trading hours. Hence, you don't have to wait until 4PM or the next day to find out what you paid for the shares. This can be important in unstable markets.
You are not exposed to the trading styles, personal agenda and sheer good luck of the fund manager.
ETF shares can be bought and sold anytime with limit, stop, and market if touched orders. Mutual funds can only be bought at days end and at end of day market prices (unless you're a friend of the management, in which case the books may be kept open a little longer, per Elliot Spitzer.)
Many ETFs have put and call options as well as being able to be bought on margin and sold short. These would allow an investor to hedge his exposure in a fund holding rather than buy or sell his holdings and thereby generate long term or short term capital gains.
The investor always knows what the fund holds. Conventional fund holdings are not transparent, being reported only quarterly at most. Hence, when a Merck-Vioxx type situation comes up, you may not know your exposure for three months. Also, you aren't exposed to short term portfolio style changes a manager may make between reporting periods to try to make up performance shortfalls.
Even if you have avoided mutual funds and made your own selection of individual securities in the past, ETFs provide instant diversification through one purchase versus the cumulative commissions for the purchase of a multiple of positions.
Having decided to invest in ETFs is not a one-decision choice. There are a multitude of choices as to the market index to follow and whether you want:
A portfolio geared toward growth, income or a blend.
USA, specific country or global exposure
A broad market or industry specific fund
A link to commodities or currency
While many investors are reluctant to choose individual company stocks or rely on a fund manager to make equally iffy choices, ETFs are much easier to select. You read that energy prices are rising and likely to stay high for some time. It's not hard to assume that energy and energy service stocks will benefit. You read that drug manufacturers face a list of woes from product license expirations, to cross border drug importing to undisclosed side effects, to Congressional scrutiny. It doesn't take a genius to see this sector as flat for a while.
The goal of one ETF advisory firm's newsletter is to provide guidance as to which sectors are going up and which are in decline. The newsletter also sees a need to differentiate specific funds by their characteristics. Many funds claim a link to a specific index, but are often only "representative samples" of that index. This is because stock indexes were not created to be portfolios to be bought, but rather, to be a snapshot of the market.
As such, there are ETF indexes which are better and worse for what an investor wants to achieve. There are also ETFs which are tax friendly and others not. There are ETFs that lack diversity as measured by concentration of investment in the top ten holdings. The newsletter offers to advise readers about strategies that can be used to hedge risk or enhance returns. Finally, fees do count and will be compared t Looking forward, ETFs are early in an evolutionary cycle where more and more intellectual input will be provided.
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