Vanguard Group introduced the first passive investment product, the index mutual fund, in 1975. We’re very proud that our Chief Investment Officer, Burt Malkiel, inspired Jack Bogle, the founder of Vanguard to create the index mutual fund when he published his groundbreaking book, A Random Walk Down Wall Street, in 1973. Eighteen years after Vanguard launched the first index mutual fund, State Street introduced the first exchange-traded fund. ETFs have grown to more than $2 trillion in assets, having recently surpassed index mutual funds. Practically speaking, it wasn’t until the ETF became popular, around 10 years ago, that passive investing could broadly appeal to the masses.
An ETF is a basket of investments, which, like an index mutual fund, mirrors an underlying sector or index. It can be broad, like a fund that mirrors the S&P 500®, or narrow, like a fund that mirrors the performance of say, Turkish manufacturers. ETFs usually have lower fees than comparable actively managed mutual funds because they do not require investment research and have much lower transaction costs.
However, unlike index mutual funds, ETFs can be freely traded by any brokerage firm. This has freed index fund issuers from the previous limitations of one-off distribution agreements with individual brokerage firms, and the associated myriad fees and subsidies. Thanks to this change we now have access to a broad, open platform of high quality, inexpensive index-based investments to choose from.
There are several other ways, in addition to how easy they are to trade, that ETFs are superior to their index mutual fund ancestors.
- ETF expense ratios are lower
ETFs are almost always even less expensive than their comparable index mutual funds. ETFs’ lower selling costs due to their far greater breadth of distribution allows their issuers to maintain the same level of profit they earn with their index mutual funds at much lower expense ratios. Lower expense ratios enable elasticity of demand, which creates a virtuous cycle. Competition has driven many ETF expense ratios below 0.15%, and some are below 0.10%. The weighted average ETF fees on the average Wealthfront client portfolio are now only 0.14%.
- ETFs are more liquid
ETFs trade like stocks, which means they can be traded throughout the day and therefore have more liquidity. That’s inconsequential to most buy-and-hold investors, but still worth noting. It’s more important that many index mutual funds have exit fees, or loads while ETFs typically do not.
- ETFs enable low-cost investment advisors
Automated investment services like Wealthfront were only made possible because ETFs can be traded electronically through Application Programming Interfaces (APIs) like stocks. Eliminating the human element of managing a portfolio significantly lowers the cost of providing advice to the consumer.
- ETFs enable services like tax-loss harvesting
Because they can be traded electronically, ETFs make it possible for automated investment services like Wealthfront to broadly offer services previously only available to the very wealthy, like continuous tax-loss harvesting. (Tax-loss harvesting is a technique by which previously unrecognized investment losses are harvested to offset taxes due on your other gains and income).
Enter a New Type of ETF
The incredible success of ETFs has caused a number of traditional mutual fund issuers to think about new types of services that could be packaged as ETFs. This new type of product is known as an “active ETF.”
Active ETFs
Unfortunately, many actively managed mutual fund issuers wanted to take advantage of the ETF’s popularity and developed something called an active ETF. They decided to game the system by creating ETFs that did not track an index, but instead followed whatever unique methodology, strategy or investment objective their issuers were trying to sell. Unlike passive index tracking ETFs, active ETFs have fees similar to traditional actively managed mutual funds, often greater than 1% annually. Their only advantage relative to traditional mutual funds is they can be traded intra-day like stocks and for much lower commissions than a mutual fund would likely incur.
Fortunately, the investment community has been smart enough not to fall for this wolf in sheep’s clothing. According to the Investment Company Institute, which tracks the fund industry, actively managed ETFs hold only around $15 billion in assets out of the $2 trillion of total ETF assets.
Disclosure
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About the author(s)
Davis Janowski is Wealthfront's editor. Before joining Wealthfront he was most recently technology columnist for InvestmentNews; prior to that he served in various roles with PC Magazine including editor, analyst and reviewer. He holds a Master of Arts degree in magazine journalism from the S.I. Newhouse School of Public Communications at Syracuse University. View all posts by Davis Janowski
