ETFs and Zero Transaction Fees
In 2019, I wrote the article you see below. At the time, I was extremely excited about the prospect of ETFs beginning to trade at zero cost, and frankly, I still am. Free trading of ETFs (and stocks in many cases) is a huge advancement for investors and gives us, as your financial advisor, additional tools to manage your portfolio. Below is a quick refresher on the history of ETFs, which explains what happened in 2019 and why I was excited about it. I have added additional commentary to the original article in italics.
The recent news from Charles Schwab, TD Ameritrade, and E-Trade declaring that they will be reducing commissions on Exchange Traded Funds (ETFs) and Stocks to $0 is huge news. (Fidelity shortly after followed suit, reducing their ETF commissions to $0 as well.) The road to $0 commissions (transaction fees) has been a long time coming. From the birth and proliferation of the discount broker in the 90s, transaction costs have been shrinking.
We at FSG are thrilled with this development. For years we have believed that ETF(s) are a fantastic tool for investors. When we partnered with TD Ameritrade in 2017, we significantly expanded our use of ETF(s) due in part to the ability to use hundreds of ETF(s) with zero transaction fees and hundreds more for a minimal cost. (Since 2019, we have, of course, added Fidelity, Schwab, and several other custodians as options). The benefit of being able to trade, rebalance, invest more, or take income from an account without having to worry about transaction fees or hidden account fees has a huge positive impact over time. This benefit, along with other perceived structural advantages ETF(s) have and are a big reason why FSG uses them alongside Mutual Funds. (Over time, our utilization of ETFs has increased, and our utilization of Mutual funds has decreased.)
At this point, you might be asking yourself, what is an ETF? Perhaps I have gotten ahead of myself with this writing. To put it simply, an ETF is a financial instrument that works very similarly to a mutual fund. ETF(s) own investments such as stocks and bonds, just like mutual funds; however, there are major differences in how ETFs function, which helps lower costs and adds transparency for investors.
With traditional mutual funds, investors buy and sell (redeem) shares of the fund from the mutual fund company. This is typically an overnight cycle, and it means that the mutual fund must hold onto enough cash to pay investors that might wish to sell. That cash could otherwise be invested. An ETF, on the other hand, is bought and sold from other investors or from market makers who are authorized to create shares on behalf of the ETF distributor. When ETFs are bought and sold on the open market, the transaction is often executed in fractions of a second and at a lower cost than mutual funds. (The speed in which these trades happen means that investors are able to make intraday trades that are fulfilled nearly instantly.) The process by which ETFs are traded also means that the mutual fund company is not involved, therefore, removing a layer of cost. Even before the recent announcements by TD Ameritrade and others, it was common to buy or sell an ETF for $4.95 a trade compared to $20 for an institutional mutual fund. (Of course, investors have been able to buy mutual funds at zero trading fees for a long time; however, those funds usually carry a “load.” This load means internally, the fund is more expensive and can dramatically impact returns over time.)
In addition to how ETFs trade, how they invest also differs from mutual funds. A traditional mutual fund could be active (trying to beat a stated index), passive (look similar to an index), or it could be an index fund simply trying to clone an index. Active funds, in particular, charge a premium for their management abilities. Most industry statistics have shown it is very difficult for these funds to beat their index after fees. This is where ETFs come in. ETFs, by and large, track an index at a very low cost. (In recent years, active ETFs have become more prevalent. Additionally, other types of ETFs, such as leveraged, buffered, and algorithmic, are also growing in popularity.) This means that you can essentially buy an ETF for no transaction fee that will track an index at a cost that is the same or lower than a comparable mutual fund which will charge a transaction fee.
Due to the reasons I have highlighted and a handful of other more technical reasons, ETF(s) have grown drastically in popularity. According to ETF.com, as of this July, U.S. ETF(s) had more than $four trillion invested in them. (That number is now up to $5.2 trillion!) That is pretty dramatic for an instrument that only debuted in the U.S. in 1993! For those that are interested in the story of the first U.S. listed ETF, here is a good read: https://www.linkedin.com/pulse/story-behind-spy-very-first-us-listed-etf-jim-ross-1/.
In summary, State Street Global Advisors released the first U.S. ETF in 1993, which launched their household brand of "SPDR" ETF(s). Interestingly enough, the first U.S. ETF is still the largest in the world.
Like any other financial product, ETFs are a tool. If used correctly, they can provide low cost, transparent, and efficient access to capital markets. Mutual funds are still a fantastic tool that we implement, and when we believe it benefits our clients, we use both mutual funds and ETF(s) to create diversified portfolios. Of course, both of these products invest in markets that have risk, which is why you should ensure you understand the risk of investing. As always, FSG strives to ensure you are comfortable with the risk in your portfolio, and we will continue to be relentless in providing the best service and tools for your benefit!
Written by: Brice Carter
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