The Wave of the Future?

 

By: Jan Paul C. Ferrer

 

It’s no secret that exchange-traded funds (ETFs) sales have been on a tear in recent years. Assets invested in ETFs have grown sharply and now total more than $1.7 trillion.1 What’s more, the number and variety of ETFs has mushroomed. As of May 31, 2014, there were more than 1,300 ETFs available in the United States alone, and they span an ever-increasing range of asset classes, including stocks, bonds, real estate, commodities and currencies—not to mention a plethora of styles, such as growth, value and cap-specific strategies.

In comparison, the number of mutual funds has shrunk in recent years, down from 8,019 funds on Dec. 31, 2008, to 7,297 funds as of May 31, 2014. But although the number of mutual funds has shrunk, the annual growth in assets under management has been healthy —9.2% over the same period.1

This uneven growth trend has captured the attention of investors, prompting questions about what this means for the future. Are ETFs “the new mutual funds”? Are they “better” than mutual funds? Should you favor one over the other? The answers here depend largely upon how you invest and what you seek in your investments, as both vehicles have different features that may suit them better for different purposes and investing practices.

The Basics

Exchange-traded funds were first conceived back in the 1980s as a way to track index performance while combining the diversity of a mutual fund with the liquidity of a stock. The first ETF was introduced in 1993 with the debut of Standard & Poor’s Depositary Receipts (SPDRs, or “Spiders”), which tracks the performance of the S&P 500 and remains the largest ETF in the world.

Like mutual funds, ETFs pool investors’ money to purchase a portfolio of securities. These securities typically reflect the composition of an index, such as the S&P 500 or the Dow Jones Industrial Average. Like a stock, ETF shares trade on a stock exchange throughout the trading day. Although ETFs calculate an end-of-day net asset value (NAV), investor demand determines intraday prices.

In contrast, mutual funds are not traded on stock exchanges. Shareholders buy mutual funds either through their financial advisor or directly from a fund company. Mutual funds are “forward priced,” which means that all orders received during the trading day receive the same price per share, based on a fund’s NAV, which is calculated once a day at the end of the trading session.

Although earlier versions of ETFs tracked only the major stock indexes, they gradually expanded to include more focused indexes that track specific sectors, styles or geographic areas, as well as bond indexes. More recently, a growing number of ETFs now track currencies or commodities as well. Additionally, there are leveraged and inverse ETFs that seek, on a daily basis, to deliver a positive or negative multiple of a given index, such as the S&P 500, magnifying the index’s ups or downs. Leveraged or inverse ETFs generally seek their investment objective on a daily basis and investors should not expect the ETF to track the returns of the benchmark index for periods other than a single day, particularly during periods of market volatility where the compounding effects of leverage can be significant.

ETFs Versus Mutual Funds:

Differences to Note Tradability ETFs trade like stocks, allowing you to trade them intraday, short or on margin.

Fees ETFs generally have lower fees than mutual funds, although the gap between the two has narrowed.

Turnover

ETFs have lower turnover than actively managed mutual funds, resulting in fewer capital gains or losses to report each year.

Variety

There are many more mutual funds than ETFs to choose from, however, ETFs are catching up. Both mutual funds and ETFs are pooled funds that offer a vehicle for investing in a pool of securities with a stated objective. But the two differ on a number of fronts, most notably tradability, fees, turnover and selection. Active Versus Passive Unlike mutual funds, most ETFs are passively managed, in that they track an index and do not require managers to research and select specific holdings. While some indexes are wide in scope (e.g., S&P 500), others are narrow (e.g., MSCI Japan), and some are based on proprietary indexes intended to track very specific segments (e.g., Barclays 1-3 Year US Treasury Index).

More recently, some actively managed ETFs have been introduced, meaning they invest in a portfolio of securities that is actively managed by investment professionals, similar to most mutual funds. As of December 31, 2012, there were 319 actively managed ETFs.2

The focus on passive management has allowed ETFs to operate with lower expenses in comparison with actively managed funds, resulting in lower fees, which in turn translates to better net returns to investors. In fact, fees across the board—for both active and passively managed funds—are lower for ETFs than mutual funds. Keep in mind, however, that brokerage commissions apply to ETF trades, whereas mutual fund charge sales loads, distribution (12b-1) fees and sometimes surrender charges on redemptions.

Fees At A Glance

As of Dec. 31, 2013

Mutual Funds                         ETFs

Actively managed funds

1.24%                                         0.92%

Passively managed funds

0.63%                                         0.52%

All funds

1.20%                                         0.60%

Source: Morningstar. Based on the average of all funds within the Morningstar fund universe.

Which Works Best for You? Whether a mutual fund or ETF works best for you ultimately depends upon your investing needs.

• For buy-and-hold investors, the differences between ETFs and mutual funds are relatively minor. Both offer liquid vehicles for investing in diversified portfolios, and both offer a wide range of asset classes and investment styles. Although fees are currently higher for mutual funds, they have come down; and the gap between the mutual funds and ETFs has narrowed, given how closely the two vehicles compete for the same investors.

• Investors looking for active management are probably better off with mutual funds—for now at least—given their overwhelmingly greater numbers and variety. For those seeking a passive approach, ETFs offer a wide selection and lower fees.

• For retirement investors, the choice between an ETF and a mutual fund is often moot. Most employer-sponsored retirement savings plans, such as 401(k) or 403(b) plans, do not currently offer ETFs as an investment option, although that appears to be changing as ETFs expand into new areas.

• For active traders, ETFs offer the greatest advantage over mutual funds because they can be traded intraday and shorted or bought on margin similar to a stock. ETFs also offer a simple way to invest in currencies and commodities.

Given the different strengths that both ETFs and mutual funds have to offer, it’s probably safe to say that ETFs will not replace mutual funds any time soon. Rather, they will continue to complement them, serving different purposes for different investor needs.

Contact me to help determine which works best for your particular situation.

Footnotes/Disclaimers

1Source: Investment Company

Institute, 2014 Investment Company

Fact Book, May 2014; “Exchange- Traded Funds,” June 27, 2014.

2Source: Morningstar. Based on the classification of all ETFs tracked by Morningstar as of December 31, 2013.

If you’d like to learn more, please contact Jan Paul Ferrer An investment in an exchange-traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock prices. The investment return and principal value of ETF investments will fluctuate, so that an investor’s ETF shares, if or when sold, may be worth more or less than the original cost.

Investors should carefully consider the investment objectives and risks as well as charges and expenses of a mutual fund or exchange traded fund before investing. To obtain a prospectus, contact your Financial Advisor . The prospectus contains this and other information about the mutual fund or exchange traded fund. Read the prospectus carefully before investing.

Article by Wealth Management Systems, Inc. and provided courtesy of Morgan Stanley Financial Advisor.

The author(s) are not employees of Morgan Stanley Smith Barney LLC (“Morgan Stanley”). The opinions expressed by the authors are solely their own and do not necessarily reflect those of Morgan Stanley. The information and data in the article or publication has been obtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of Morgan Stanley. Neither the information provided nor any opinion expressed constitutes a solicitation by Morgan Stanley with respect to the purchase or sale of any security, investment, strategy or product that may be mentioned.

Morgan Stanley Financial Advisor(s) engaged Via Times to feature this article.

[Jan Paul Ferrer may only transact business in states where he is registered or excluded or exempted from registration [http://www.morganstanleyfa.com /ferrer. Transacting business, follow- up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Jan Paul Ferrer is not registered or excluded or exempt from registration. ©2014 Morgan Stanley Smith Barney LLC Member SIPC.

CRC 974343 [07/14]