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What’s an ETF?

How ETFs Work
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If you’re a cost-conscious investor who wants to diversify, consider ETFs. Michael Iachini, managing director of ETF research at Charles Schwab Investment Advisory, explains why.

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Rick Karr:
Michael Iachini stepped into the world of exchange-traded funds as a researcher in 2004. That gave him a front row seat as ETFs came into their own over the next decade. Millions of investors have added them to their portfolios, and more new funds and asset classes are available all the time. Iachini thinks millions more will take the plunge once they understand the basics better. He’s here to help on this installment of the Insights & Ideas podcast, brought to you by Charles Schwab.

I’m Rick Karr. It’s hard to miss the enthusiasm when Michael Iachini talks about ETFs. In part, that’s because they’ve been growing so fast. But he says there’s a more important reason.

Michael Iachini:
The whole presence of ETFs has been great for investors because it’s opened up a lot of asset classes in parts of the market that would be really hard to access otherwise, and has done it in a way that’s really brought costs down a lot.

There’s a lot of competition among different ETF providers, so those costs keep coming down year after year, and that’s exciting. And it is an area that a lot of investors still have a lot to learn about. A lot of investors are not ETF experts yet, but they want to be. They want to learn more.

Rick Karr:
Exchange-traded funds and mutual funds have a lot of similarities. But there are also some key differences.

Michael Iachini:
When you place a trade in a mutual fund, you can say, “I want to put $5,000 into this fund,” or whatever amount you want. And at the end of the day, the fund manager figures out how much all the stocks or bonds that they own are worth. And they say, “All right, on a per share basis, that’s $10 per share.” And they figure out how many shares your $5,000 buys you, and they give you those shares. So nothing actually happens with your investment until the end of the day.

Trading shares of an ETF, on the other hand, is a lot like trading shares of a stock. So, ETFs trade on exchanges. That’s why they’re called exchange-traded funds. And they’ll have a ticker symbol, and you can enter that in and place a trade at 10:30 in the morning and say, “I’m going to buy now,” or “I’m going to sell at 11:15.” You can set a limit price. You can trade on margin. So you have a lot more trading flexibility with ETFs than you do with mutual funds.

Rick Karr:
The first ETF hit the market in 1993 and not much happened for a few years. Standard & Poor’s depositary receipts are still around tracking the S&P 500, but the name you’ve probably heard is SPDRs. It became the world’s largest ETF when individual investors discovered it. But Iachini says it wasn’t intended for individual investors.

Michael Iachini:
It was intended for institutional investors. So you’re talking about in pension funds, or hedge funds, or foundations or endowments that might have a need for something big and liquid to help them track the market. If they have extra cash on hand, they could put it in a product like this, this new ETF thing, and for the first 10 years or so, most of the use really was on the institutional side.

As we got into the early 2000s, financial advisors and their clients as well as individual investors started realizing that, “Hey, this ETF thing is kind of interesting.” And so you started seeing new companies launch products, and you started seeing much more variety of products. But that massive influx of new ETFs, new companies playing there, has been really good for investors because they have more variety and have more types of products they can invest in. And a lot of cost competition, too. So the cost of ETF investing has come down steadily over the years.

Rick Karr:
These aren’t just stock funds anymore. Can you give us a sense of the range of ETFs that are out there?

Michael Iachini:
The range of ETF products is vast. And part of the appeal of ETFs, frankly, is that you can probably find an ETF to invest in pretty much anything you might want to buy. So, certainly there’s tons of U.S. stock ETFs, tons of international stock ETFs. And within those markets you can find small-cap international stocks or emerging market stocks getting you exposure to countries like Brazil, China, India and such.

But moving beyond stocks entirely, you can find bonds of course: U.S. Treasury bonds, but also corporate bonds, mortgage-backed bonds, international bonds, high yield bonds or junk bonds that are risker, but tend to pay more interest. And then moving beyond the kind of traditional asset classes, you can find ETFs that invest in real estate, REITs, or commodities like oil or gold, or diversified baskets of commodities.

There are even some ETFs out there that do some pretty exotic things with volatility, trading the VIX. And some of those get pretty darn risky. Really not intended for most everyday investors.

Rick Karr:
Should investors be using the same criteria to pick an ETF that they use to pick mutual funds?

Michael Iachini:
Yeah, there are a lot of similarities. So you want to start by figuring out: What part of the market do I want to get exposure to? And make sure you look at ETFs that give you that exposure. You might think that, “Hey, I’m just going to pick the cheapest ETF out there,” but if you want small-cap stocks, or you want short-term bonds or you want certain commodities, you need to filter that part first.

Now how do you pick among the different options that are there? Well, largely it’s a question of cost. And the costs that you want to pay attention to are, number one, something called the expense ratio. And the expense ratio is going to be a percentage, something like 0.15% or 0.06%, etc. And that’s the percentage of your money that you’re going to lose every year that you own the ETF to cover the manager’s expenses. The nice thing about ETFs is these expense ratios tend to be very low compared to actively managed mutual funds. But they’re not zero, and they do differ among ETFs. So you want to focus on ETFs with a low expense ratio.

Rick Karr:
What about the size of the fund? Is there a difference between large ETFs and small ones?

Michael Iachini:
There’s a bit of a difference between large and small ETFs. The biggest issue I would say is you want to be careful about investing in very, very small ETFs. So using a threshold of $20 million, which is not very much in the ETF world, anything below that it can be tougher to trade.

If an ETF has a lot of assets, then it probably means there’s more market makers out there who are actively buying and selling that ETF all day long, and that’s good for investors. You want there to be lots of market makers because that means they’re competing with one another for the price. So you want to get the best price you possibly can. And if there’s only one market maker, well, you’re going to have to take whatever they give you. So very small ETFs sometimes don’t have very many market makers, and that means that the price that you pay might not be great.

But really it’s more of an issue of making sure you stay away from the very small end. So if you look at an ETF that has $100 million in assets versus a billion dollars in assets versus $10 billion in assets, the bigger ones might be a little more easy to trade. But realistically, once you get into that $100 million-plus range, you’re probably going to be pretty happy with the way you can trade the ETF. And getting a whole lot bigger doesn’t make that much of a difference.

Rick Karr:
I want to get back to the idea that the ETFs can be traded over the course of a day. If there’s a day with a lot of volatility on the market, are ETFs ever affected by that?

Michael Iachini:
Yeah, most of the time ETFs tend to trade pretty well. And by pretty well, I mean they trade in line with the market. So if you have an ETF that tracks the S&P 500, and the S&P 500 is up 1% within the day, the ETF is probably up 1% in value within the day, too. But you can have situations where the price that people are actually trading the ETF at on the exchange could be significantly higher, or significantly lower, than the value of the underlying stocks.

So we saw a day in late August of 2015—August 24 was the date—and there were a number of ETFs that for short periods of time, less than an hour, traded at big discounts to the underlying value of their stocks. And that was because the stock market was extremely volatile at the open. Some stocks hadn’t even begun trading yet because market makers were still trying to figure out what everything was worth.

So, a lot of people who normally would be trading the ETF actively and keeping that price in line with the value of the portfolio, they sort of backed away because they weren’t sure what was going on. It was over within an hour, and these things are pretty rare.

But it’s important for investors if you’re going to trade an ETF to pay attention to hey, what’s the price of this ETF done so far today? What’s the overall market done so far today? And if there’s a big difference there, you might want to hit the pause button. Just wait a little bit and see, okay, what’s going on? There might be a temporary difference in price between what this ETF is really worth and what people are trading it for right now.

Rick Karr:
Even having said that, given the range of products that are available at a low cost, is there any reason to opt for a mutual fund over an ETF?

Michael Iachini:
Right now, you see around 1,600 ETFs out there on the market. Very few of them, a hundred-ish, a hundred plus, are actively managed. The vast majority of them track some kind of index. And some investors want active management. They don’t want to just get the market return. They’re okay with paying a little bit more in expenses to have an active manager who will try to add value and do better than the market.

In the world of mutual funds, you have thousands of choices of active managers, some of whom have a very long track record, some of whom investors believe in and want to invest with. And those just aren’t available on the ETF side. So that’s one big area where you’ll see people gravitate toward the mutual fund.

Another is in retirement plans. Right now, there aren’t very many retirement plans that have ETFs available. And some of that is just the legacy of how the 401(k) business has been built up over time. It was really built to handle mutual funds. So for those situations, investors are going to be using mutual funds because that’s what’s available to them.

Rick Karr:
Michael, thank you so much. I really appreciate it. This has been a lot of fun.

Michael Iachini:
My pleasure. Thanks, Rick.

Rick Karr:
Michael Iachini researches ETFs and mutual funds for Charles Schwab Investment Advisory. And that’s it for this installment of the Insights & Ideas podcast brought to you by Charles Schwab. You can find us on iTunes or at insights.schwab.com. My name is Rick Karr. Thanks for listening.

Important Disclosures

Some specialized or “niche” exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value. All ETFs and mutual funds are subject to management fees and operating expenses.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies and securities mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

Performance may be affected by risks associated with non-diversification, including investments in specific countries or sectors. Additional risks may also include, but are not limited to, investments in foreign securities, especially emerging markets, real estate investment trusts (REITs), fixed income, small capitalization securities and commodities. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

Margin trading increases your level of market risk. Your downside is not limited to the collateral value in your margin account.

The VIX is a market volatility index published by the Chicago Board Options Exchange. It is tied to the amount of volatility that traders expect to see in the Standard and Poor’s 500® Index over the next month.

Charles Schwab Investment Advisory, Inc., is an affiliate of Charles Schwab & Co., Inc.

(1115-9SY6)

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