The ETF: A Primer on the Most Exciting New Three Letters in Finance

Posted by Alex Frey (@alexhfrey )

The most intelligently conceived asset-allocation does little good unless it is actually implemented somewhere in an investor's portfolio. In the past, investors had to go to mutual funds to implement a diversified asset allocation. But today, they have a great new option: Exchanged Traded Funds, commonly known as ETFs. 

ETFs have become the cool, :"new kids on the block" in the financial world lately - and with good reason. They can be great instruments for individual investors to get low-cost exposure to the markets. This article will look at what ETFs are, how they are classified, and what you should consider in picking one. 

What are ETFs?

The popularity of ETFs is a result of their unique combination of the best features of individual stocks and mutual funds.

Like individual stocks, ETFs can be traded instantaneously on highly liquid markets like the New York Stock Exchange through any broker. Furthermore, they are extremely low-cost, transparent, and tax-efficient. 

Like mutual funds, ETFs are diversified instruments that enable investors to own a share in hundreds of individual companies by purchasing a single fund. ETFs usually most closely resemble index funds in that they track a broad group of stocks, such as all US stocks, and seek to match the performance of this group rather than to exceed it by actively selecting stocks (though there are some actively managed ETFs - discussed later). 

The mechanics of how ETFs work are interesting, but not terribly important to understand to grasp the way the securities will move in the markets (so skip ahead if you want...). Essentially, the company running an ETF publishes its holdings every day. Investment Banks and other institutions can then individually buy up the ETF's holdings in the market and give them to the ETF provider in exchange for a new "unit" (which represents many shares) in the ETF. Because of this, the number of shares of an ETF can naturally grow and shrink depending on market demand for it. 

Classifications and Major Providers

There are now almost as many ETFs are there are common stocks. The website classifies ETFs into more than 100 categories. There are funds that track the stocks of just about any industry, region, market-cap, style, or combination thereof. Other ETFs have "unique" features like using leverage (borrowed money) to go up (or down) twice as much of an index. 

Fortunately, for most purposes, a lot of this is marketing noise that can be dismissed by long-term investors who want to construct a rational asset-allocation while minimizing expenses. There are four main providers of ETFs that warrant a look for such investors. They are Vanguard, iShares, Schwab, and State Street / SPDR. Each of their offerings in the main asset classes are provided in the table below. 

Asset Class Vanguard Offering Schwab Offering SPDR Offering iShares offering
US Stocks (Total Market) VTI SCHB TMW ITOT
Emerging Markets Stocks VWO SCHE GMM IEMG
International Stocks - Developed Markets VEA SCHF GWL IEFA
Total Bond Market BND SCHZ LAG AGG
REITs - International VNQI   RWZ IFGL
Gold     GLD IAU
Global Stocks (All-World) VT   DGT ACWI
Major ETFs classified by provider and asset class

Considerations in Choosing an ETF

It may seem obvious, but is worth repeating - the most important consideration is the asset-class or group of securities that the ETF tracks. No matter how cleverly they are marketed or packaged, an ETF tracking US stocks will far more resemble another ETF tracking US stocks than it will one tracking, say, Global Real Estate. 

In choosing between two or more ETFs that track the same broad asset class, there are two important things to consider: the ETFs annual management fee, and its liquidity. 

An ETF's liquidity is important because ETFs that trade more heavily will be easier to get in and out without paying an implicit transaction cost. An implicit transaction costs results from what is known as the "bid-ask" spread that occurs when there is a significant difference between the highest price someone in the market is willing to pay to purchase shares, and the lowest price someone is willing to sell them for (you can think of the difference as going to the "dealer").

Good proxies for the liquidity of an ETF are the number of shares (volume) and the total amount of assets invested in the ETF (net assets). The largest ETFs hold billions of dollars in assets and see millions of shares traded every day, but smaller ETFs may hold less than $50 million in assets and see only thousands of shares traded a day.You can find these numbers on major financial websites. The screenshot below shows where they appear on Yahoo Finance for the Vanguard Total Stock Market Index Fund (VTI). 

Finding Etf Liquidity How to find the liquidity of an ETF using Yahoo Finance.

The other consideration - which is arguably even more important, especially for smaller accounts - is the fund's management fee, or annual expense ratio. This is money that will be automatically deducted from the fund every year to pay the management company. This crucial number is a bit harder to find on Yahoo Finance - you have to click on "Profile" under the "ETF" menu, and then find the "Fund Operations" Box (pictured below). In the case of the Vanguard fund, the expense ratio is a rock-bottom .05%. Expense ratios for most ETFs should be under .20%. 

Where To Find Etf Expense Ratio

Finding Etf Expense Ratio

Finally, if your discount brokerage offers a set of commission-free ETFs, you may want to consider this in your decision, as you will otherwise have to pay the normal trading costs that your brokerage charges to enter into or exit a position. 

As an example, below is a comparison of the major total US Stock Market ETFs:

ETF Provider Annual Management Fees Assets Under Management Average Daily Volume Commission-Free Availability
VTI Vanguard .05% $200 billion 1.6 mil Vanguard, TD Ameritrade
SCHB Schwab .06% $1 billion 270k Schwab
TMW SPDR .20% $.5 billion 4k  
ITOT iShares .20% $.5 billion 32k  

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By Alex Frey