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Sound Advice, September 14, 2022

 Why Exchange-Traded Funds?

It’s hard to believe, but the first mutual fund was created almost 100 years ago.  That was Massachusetts Investors Trust, which was born in 1924 and opened to investors in 1928.  Other funds then came along, though it took four decades for them to develop a substantial following.

The reasoning behind the development of mutual funds was simple.  They offered diversification.  Why buy one or several individual stocks when you could buy funds managed by professionals who could make well-considered selections from the broad universe of all stocks.

The logic seemed reasonable and investors climbed aboard in huge numbers.  But there was more than one hitch.  In those good old days, the cost of making mutual fund investments was rather hefty.  Indeed, the loads (a.k.a., sales charges) for purchases of fund shares tended to be in the upper single digits.  Loads of 8.5% of the amount invested were not uncommon.  So if, for example, you invested $10,000, you began with a loss of $850.

Even if you made a larger investment, there was still a load, though it may have been at a reduced rate.  Not only were these charges of concern, but there was also the cost of managing the funds, which was not inconsiderable.

So it came as no surprise that sales loads were under heavy pressure.  Later on, many funds reduced those charges and some eliminated them completely.  Now, funds with loads are in the area of 5.0%.  Management charges, whether for load or no-load, tend to range between 0.75% and 1.25%.

Then we come to the issue of active management versus passive management.  Active management means there are professionals analyzing and selecting holdings for the fund’s portfolio.  Passive management means the fund’s holdings are intended to duplicate those of an index; there is no active management and the cost is lower.

The hitch is that even though professional management may yield better returns, the cost of that management is greater than the increase in returns.  Thus, in most cases the cost of professional management is not justified by the improvement provided, which is why the popularity of passive funds has continued to grow.

But there’s more.  Unlike stocks, which are bought and sold throughout the trading day, fund transactions take place after the 4:00 p.m. close of trading each day.

The logical next step was the introduction of exchange-traded funds (ETFs), which trade like stocks.  The first of these was SPY, the ETF that mimics the Standard & Poor’s 500 Index.  Now there are more than 8,500 ETFs.  ETFs are available for a broad range of indexes, including equities, both domestic and international, bonds, currencies, commodities, and alternative investments.

The ongoing cost of ETFs is usually much lower than that of mutual funds and there are often ETFs that are similar, if not identical, in holdings to mutual funds offered by the same sponsor.  All of this ends up explaining why investment professionals have increasingly turned to ETFs to round out the portfolios of their clients.

N. Russell Wayne, CFPÒ

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