Because Exchange-Traded Funds, or ETFs, allow investors to achieve diversification at low cost, and diversification is important because it can mitigate investors’ risk, let’s take a look at the ETF.
The ETF is a pooled vehicle that owns underlying investment assets, such as stocks, bonds, real estate, commodities and currencies. The vast majority of ETFs are managed passively — meaning the individual investments represent part of an index, and no discretion is involved. ETFs are traded throughout the day on public stock exchanges, and more than 5,000 ETFs are sold globally.
The first ETF was offered in the United States in 2003 by State Street with the ticker SPY. It holds stocks in the S&P 500 Index. As previously noted, ETFs help investors diversify with low cost. For example, rather than purchase 15-20 stocks in the S&P 500 Index, investors instead could purchase the SPY.
How an ETF differs from a Mutual Fund
Like an ETF, a mutual fund is a pooled vehicle that invests in underlying securities and provides diversification — but these two differ in some key ways. Among them:
- Most mutual funds are actively managed by a portfolio manager who is trying to beat the market based on his or her skill and expertise. Much has been written about the fact that the majority of managers do not beat their respective index.
- Nearly all mutual funds are “open-ended,” which means investors will buy or sell their shares directly from the fund provider rather than sell to another investor. Trade settlement happens at the close of a business day. Under this structure, if more investors are selling than buying, the fund will be required to sell underlying assets to meet redemption requests. Any resulting capital gains on those sales will be recognized by all investors in the fund, regardless of whether they sold their shares in the mutual fund. Net redemptions are more common during bear markets when investors become nervous, often leaving remaining investors with the doubly unattractive result of falling mutual share prices and taxable capital gains.
- Because most ETFs are passively managed, they typically charge a much lower fee than actively managed mutual funds that must pay the investment manager and his or her team of professionals. Given how unlikely it is that a manager will beat the benchmark in any given year, the additional fees may be hard to justify.
For a great visual explanation of the differences between ETFs and mutual funds, see the chart designed by Visual Capitalist below.
ETF investments in Cardan Capital portfolios
At Cardan Capital Partners, our portfolio strategies are almost exclusively comprised of ETFs. We favor ETFs because of the low cost, the reduction of individual security concentration risk in any particular asset category, and the trading efficiency. Rather than actively selecting individual securities for these portfolios, we dynamically manage the allocations to asset classes through our ETF positions. So, for instance, we can overweight bonds relative to stocks or momentum stocks to value stocks.
According to research by JP Morgan, more than 90% of the variation in returns can be attributed to asset allocation versus security selection or market timing. Using ETFs allows us to make changes to portfolios quickly and cost-efficiently for our clients.
The content contained in this article represents the opinions and viewpoints of Cardan Capital Partners only. It is meant for educational purposes and not meant for consumer trading decisions. All expressions of opinion are as of its publishing date and are subject to change. There is no assurance that any of the trends mentioned will continue in the future. Market performance cannot be predicted, so nothing in our commentaries is ever meant to provide any kind of guarantee of future results.