The evolution of individual investors’ participation in the securities market has progressed from reliance on full-service brokers to the prominence of mutual funds and the advent of self-directed brokerage accounts, where investors can trade securities online.
Mutual funds offer the advantage of tracking a diversified basket of securities, but they require orders to be placed through a mutual fund dealer and cannot be directly traded. In contrast, the emergence of exchange-traded funds (ETFs) combines the features of mutual funds with online trading. ETFs can be bought or sold directly through brokerages, allowing investors to trade baskets of stocks or other securities with ease.
The ability to trade funds on exchanges holds significant benefits, particularly for individuals who actively manage their portfolios or play an active role in investment decision-making. This accessibility and flexibility make ETFs highly appealing to a wide range of investors.
ETFs are a relatively new investment vehicle that emerged in the early 1990s and have experienced steady growth ever since. They have traditionally tracked various indexes or securities, similar to index mutual funds, but with the advantage of not being limited to stocks and bonds. ETFs can be created for almost any asset class, providing investors with a diverse range of options and enhancing the versatility and utility of these instruments compared to traditional funds.
With each passing year, an increasing number of investors, ranging from individual investors trading from home to large institutional investors, are embracing ETFs. Even investors with the means to buy individual components themselves are incorporating ETFs into their portfolios, recognizing the value and convenience these vehicles offer.
Overall, the rise of ETFs has transformed the investment landscape, providing investors with greater flexibility, diversification, and accessibility to a wide range of asset classes. Their popularity continues to grow, attracting investors across various market segments.
Why ETFs Appeal to So Many
The fundamental purpose of ETFs is similar to mutual funds, which is to provide investors with the ability to own a diversified portfolio of securities without the need to individually trade each security.
In the past, investors had to buy and sell securities separately, which was both time-consuming and costly. However, investors began looking at securities indexes and realized the benefits of diversifying their positions and aiming to replicate the returns of these indexes.
Index funds emerged as a solution to this need. They seek to replicate the returns of specific indexes by holding all the securities in the index in the same proportions. While it is not possible to replicate an index exactly due to transaction and management costs, index funds provide a close approximation prior to considering these costs. Additionally, index funds are often more cost-effective than actively managed funds since passive management requires lower expenses.
Exchange-traded funds take this concept further by employing an even more cost-efficient structure. ETFs are created and managed by market makers who profit from the trades themselves without adding additional fees. In contrast, mutual funds buy and sell from these market makers and need to include their expenses on top of the trading costs.
Although ETFs do not entirely eliminate the middleman, when the middleman is responsible for structuring and managing the ETF, their involvement can make the fund’s expenses more efficient. The existence and trading of ETFs allow for lower costs, enhancing their overall cost-efficiency compared to mutual funds.
Overall, ETFs provide investors with a cost-effective investment option that allows for diversification and the potential to replicate the performance of specific indexes, thanks to their efficient structure and involvement of market makers.
The Fact that ETFs Are Traded on Exchanges is Actually a Pretty Big Deal
Exchange-traded funds (ETFs) being traded on exchanges involve investors paying a spread, similar to all securities traded in the market, whether directly like ETFs or indirectly like mutual funds.
The real-time trading on exchanges and the high demand for actively traded ETFs provide them with significantly more liquidity compared to mutual funds. Mutual funds, due to their large position sizes, are notorious for their relative illiquidity. Investors trading in large positions face challenges in moving in and out of these positions at the bid or ask prices due to the lack of sufficient volume to fill their orders.
Large orders have the potential to impact market prices significantly, attracting professional traders who specialize in profiting from the waves created by these orders. When a large order is being bought, for example, the price increases as it gets filled at different levels, resulting in an average price higher than the initial bid or ask at the time of the trade.
With ETFs, unless the order size is exceptionally large, investors can typically get filled at the prevailing market price without significant slippage. As a result, ETF trades enjoy greater liquidity and price efficiency compared to mutual funds, which must trade larger positions each time they execute a trade.
While both index mutual funds and index ETFs experience the addition and subtraction of orders as they are bought and sold, it is the operational structure of ETFs managed by those filling the orders that offers the most significant advantage. This structure allows ETFs to have lower management fees, some as low as 0.05%.
Another advantage of ETFs is the ability to enter and exit positions at any point during the trading day, even engaging in intraday trading. This flexibility appeals to a wide range of investors, from scalpers with trades lasting a few minutes to long-term buy-and-hold investors, and everyone in between.
In contrast, trading mutual funds on shorter-term timeframes is more challenging as their prices only settle at the end of the trading day, making it uncertain at what price orders will be filled. Additionally, mutual funds actively discourage frequent trading and may impose additional fees on investors who trade too often, further complicating short-term trading strategies.
Self-Directed Investment Is Really What Has Driven ETF Growth
The growth of exchange-traded funds (ETFs) can be attributed to the increasing number of individual investors who choose to manage their own investments. Many individuals have traded individual stocks and may not have achieved the desired results, leading them to seek diversification beyond what they can achieve individually due to capital constraints.
With the widespread availability of online trading platforms provided by online brokers, the ability to buy funds in this manner has become highly appealing to investors. While online trading platforms have spurred interest in futures, options, and forex trading, these instruments primarily attract short-term traders. Derivatives, by nature, are designed for short-term application, and although some traders engage in longer-term forex trading, the majority aim to capitalize on short to medium-term fluctuations, ranging from a few minutes to a few months.
- The Market for ETFs
- Buying and Selling ETFs
- Strategies with ETFs
- The Benefits of ETFs
- ETFs Compared to Mutual Funds
- How ETFs Empower Investors
- The Flexibility of ETFs
- Deciding on ETFs
- Leveraging with ETFs
ETFs, on the other hand, provide access to a wide range of markets, allowing traders to trade various assets across any desired timeframe, from seconds to decades. This versatility and flexibility make ETFs an all-encompassing approach, contributing to their growing popularity.
Even for longer-term investors, ETFs require active participation, enabling investors to take full ownership of their investments. While this responsibility places the onus on investors for their investment outcomes, it also fosters a valuable learning experience and encourages increased engagement with investments. Many investors find motivation in actively managing their portfolios, gaining competence over time. Managing an individual portfolio can be more successful than relying on others to handle a pooled fund, as it offers greater freedom and flexibility in decision-making.
While most ETFs are passive investments that track baskets or indexes of securities, the combination of ETFs chosen by an investor and the timing of their holdings can make ETF investing highly active and far from passive, if desired.
Given the appeal of ETFs and the empowerment they provide to investors, the growth in ETF volumes is expected to continue as more investors take charge of their portfolios to varying degrees and become increasingly familiar with this investing method.
