For decades, ordinary investors with modest sums to invest had limited options. With even low discount-broker commissions making a big dent into regular investments from typical paychecks, individual stocks were largely out of reach, leaving actively managed mutual funds as the primary alternative. Through active funds, money managers got used to the idea of taking 1% off the top on an annual basis, regardless of whether the funds they managed produced gains or lost money for their shareholders.
Index mutual funds have been around for 35 years, but they largely coexisted peacefully with active funds throughout most of that time. Exchange-traded funds, on the other hand, appear to be driving the nail in the coffin of traditional mutual funds. With the writing on the wall, some of the largest money-management companies have thoroughly embraced ETFs, leaving less forward-looking firms in what could prove to be a dying industry.
Why ETFs reign supreme
The primary advantage that ETFs have is their low-cost structure. By adopting investment strategies that track passive indexes rather than requiring active management, ETFs don't have to pay as much for frequent trading expenses, and they generally don't pay managers as much to implement those strategies as they would to come up with their own independent investment ideas.
Index mutual funds share that low-cost advantage with ETFs, so it's only natural to ask what ETFs brought to the table that index funds lacked. Several things set ETFs apart from their index-fund brethren:
- Intraday trading. You'll find experts on both sides of this issue, with some arguing that the ease of trading ETFs contributes to their overuse as short-term trading tools. But some of the best buying opportunities for stocks have come in the middle of the day, with the Flash Crash two years ago perhaps the most extreme example. Having the ability to jump in midday can give you a big advantage over having to wait until end-of-day pricing kicks in for index funds.
- Flexibility. Many index mutual funds require minimum investments and can therefore be challenging for beginning investors to set up. ETFs, on the other hand, are subject only to the minimums that your broker establishes, and many brokers let you open accounts with very little money and then offer their ETFs at no commission. That prevents you from having to make a big commitment to a single index fund early on before saving up enough money to diversify.
- Core strategies. ETFs make it easy to set up core portfolios using broad-based basic asset allocation strategies. For instance, BlackRock (NYSE: BLK ) recently came out with a set of 10 core iShares ETFs, including seven stock funds and three bond funds. Through various combinations of those ETFs, you can tailor your portfolio to the risk level and return potential you want.
- Tackling niches. At the same time, though, ETFs are useful for helping you make focused bets on certain parts of the market. For instance, State Street (NYSE: STT ) came out with its Sector SPDR line of ETFs years ago, allowing investors to drill down on particular industries while retaining the diversification of owning dozens of stocks within each industry.
- Transparency. ETFs also give investors the huge advantage of telling them exactly what stocks or other investments they own on a daily basis. By contrast, less frequent disclosures from mutual funds allow them to use window dressing to mask their investment decisions, making it much harder for you to judge their performance on a stock-picking level.
Wall Street hasn't completely caved in to the new low-fee reality, though. To try to preserve profits, several companies have established or are lining up to come out with active ETFs. Bill Gross' PIMCO Total Return ETF (NYSEMKT: BOND ) has become a big hit, with more than $3 billion under management. State Street and Schwab (NYSE: SCHW ) are also in line to release active ETFs. Yet while active ETFs generally have higher costs than similar index-driven ETFs, companies are generally taking a pay cut compared to their mutual funds. For instance, PIMCO's ETF has annual charges more than a third lower than its Class A mutual fund shares and is available without a sales load.
ETFs are far from perfect, but they've had a real impact on the way that Wall Street profits from managing your money. By embracing low-cost ETFs, you can keep more of your money for yourself. In a low-return environment, that's more important than ever.
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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.