ETFs are baskets of securities designed to track various market indexes (and/or asset classes), and are traded on national stock exchanges. The advantages of ETFs—low cost, diversification, transparency, liquidity/price efficiency, and tax efficiency—allow us to manage the portfolio's risk and equity exposure with rigorous precision.
Each ETF's "basket" of underlying securities is transparent and is published every day. An ETF either replicates its target index entirely or it invests in a representative sample of the stocks in the underlying index. With ETFs, you know what you own on a real-time basis.
Most ETF investors pay low management and administrative fees that are lower than those of most actively managed mutual funds. According to Morningstar, the average expense ratio for equity mutual funds (both domestic and international) is 1.32%, while the average expense ratio for all exchange traded funds is .41%. This cost difference can have a significant impact on investor returns over the long term.
Like stocks, ETFs trade throughout the day and their prices fluctuate accordingly. The pricing of an ETF closely tracks the price changes in its underlying securities. For most ETFs there is a highly liquid market, making it possible for investment managers to execute buy or sell orders as soon as market conditions change. The pricing of an ETF is efficient because ETFs offer shares through a creation and redemption process. In other words, the number of outstanding shares may be increased or decreased daily as necessary to reflect demand. This is known as an "in-kind" exchange.
Using ETFs, shareholders can invest in asset classes or sectors of the market with pinpoint precision. ETFs allow for the creation of fully diversified portfolios in which equity exposure and risk are easily measured and managed.
Due to passive management, low turnover and the unique "in kind" redemption process of ETFs, capital gains tax exposure is minimized. When redeemed, ETF shares are simply sold on the open market and the tax liability is usually based on the seller's original purchase price for the ETF. The ability to buy and sell on the open market avoids the problem that mutual fund shareholders experience when fellow shareholders redeem shares from a fund. In order to redeem those shares, the mutual fund may have to sell some of the securities it holds and realize a capital gain which is allocated to all shareholders. In addition, mutual funds are required to pay out all dividends and capital gains annually. So even if the portfolio has lost value that is unrealized, there is still a tax liability on the capital gains that does have to be realized.
In any given year, only about one-third of actively-managed equity mutual funds match the performance of their benchmark indexes. Over time it is extremely difficult for active managers to produce alpha consistently. Add the higher fees for active management to the equation and the long-term performance results look even worse. Because ETFs are designed to simply track the performance of well-established indexes, investors are not subject to the risk of the "negative alpha" produced by most active managers.