Exchange traded funds or ETFs are simply baskets of securities
that trade on an exchange. They are easily the most successful
investment product introduced over the past 30 years. In the
US, they now account for 30% of dollar volume trading, but other
markets are catching up fast. Here in London ETF volumes grew
50% last year, and now account for 12% of total volume. An ETF
is very much like a mutual fund or unit trust, but with a couple
of important differences. First ETFs trade continuously
throughout the day, rather than being settled at the close. This
is a big advantage because it allows investors to pinpoint the
exact time and price at which they transact. The second
difference has to do with taxes. With the mutual fund investors
have a tax liability for dividends paid by the components
of the fund, as well as any capital gains incurred as the
investment manager buys and sells. Those ongoing taxes then
affect the investors cost basis, which is used to determine taxes
owed when the fund is finally sold. It can get very
complicated. Fortunately, fund companies keep track of all that
and issue the appropriate tax statements to the investor. But
all that record keeping is expensive. For this reason, and
others, mutual funds usually have higher expense ratios than
ETFs. Typical fund expenses range from a half a percent to
1%. While the most liquid ETFs charge a few hundredths of a
percent ETFs have other advantages. For example, some of
the components of the ETF may be difficult or expensive to buy
outside of the ETF wrapper. As for example in emerging markets,
it's much easier to buy an ETF rather than the individual
securities in different markets, and without having to worry
about currencies or any extra fees or restrictions those
markets may impose. Initially, most ETFs were passive
instruments designed to mimic the returns of an index like the
s&p 500. In recent years, investment managers have
introduced products with broader mandates. Some of these are
actively managed to try to improve on the index returns.
One particular strategy which has become popular is called
Smart beta. The idea here is to tilt the fund toward a
characteristic which is expected to outperform such as low price
to book. Of course, ESG strategies, environmental,
social, and governance are popular nowadays. And there are
lots of ETFs designed to meet that demand. For all of these
strategies ETFs offer an easy and inexpensive way to invest
without doing the hard work of selecting individual securities.
Finally, what are the implications of the rapid rise
of ETFs? In general, I think it's a good thing ETFs have made
investing easier and cheaper. To the extent that they have also
made passive investing more popular, which I think they
have. That's also a good thing. But I'll end with one note of
caution. Most people who buy an ETF don't know what's in it, and
frankly don't care. But as ETFs and passive investing have come
to dominate the investing landscape. They have become
proxies for investing in large and expensive stocks. When
individual components of an index ETF perform well, they
become a larger proportion of the index, which means the ETF
must buy more of them, which causes them to go up even more
and so forth. It becomes a self reinforcing loop, where the
dynamics of passive investing become more important than
company fundamentals as a driver of price. After a while a
relatively small number of large expensive stocks like Apple come
to dominate the market. This can create systematic risks, because
the same forces that cause the stocks to go up can also cause
them to go down. If selling starts