Founders Perspctive

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Exchange Traded Fund (ETF). In 1993, State Street Global Advisors introduced a new structure for housing an investment portfolio, the Exchange Traded Fund (ETF). The first ETF was the SPDR S&P 500 Trust (SPY).

What is an Exchange Traded Fund? ETFs are a type of pooled investment security that can be bought and sold much like an individual stock. The main difference between an ETF and a mutual fund is that though a mutual fund is also a pooled investment, it trades only once a day after the market closes.

Benefits of ETFs. ETFs offer several advantages over mutual funds, including:

• More Transparency.

• Lower cost.

• Tax efficiency.

• Certainty.

Transparency. Traditional mutual funds only report their underlying security positions on a quarterly basis. ETF holders, on the other hand, can view the fund’s holdings more frequently.

Low cost. Although the costs of purchasing and owning mutual funds have come down tremendously over the past several decades, they still cannot compete with the low cost of most ETFs. Many of the larger ETFs have ongoing operating costs of below 0.1% per year.

In addition, as ETFs trade like stocks, they are mostly bought and sold with no costs. (Most mutual funds can also be bought with no front-end costs by the fund, but the custodian may charge a fee for making the transaction. Schwab charges $12 to Tanglewood clients for many mutual fund transactions.)

Tax efficiency. ETFs are extremely tax efficient. Partly this is due to the passive nature of their approach – like index mutual funds. In addition, ETFs have a cooperative structure with the offering institution that “exchanges” some security trades before a taxable sale.

Certainty. ETFs were originally designed to be passive index vehicles. Whatever index the ETF was following was exactly the securities it intended to hold. The underlying investments only changed as the index changed.

These advantages are attractive to both institutional and individual investors. ETFs meet the need for broad market exposure with a single trade.

Evolution of ETFs. During the 1990s and early 2000s, ETFs remained primarily broad asset class vehicles.

However, as their tax efficiency, low costs, ease of use and advancement in trading technology was validated, ETF usage expanded rapidly, from $204 billion in 2003 to over $10 trillion in 2021. See Chart 1. (The decline in 2022 was due to the bear market in stocks and bonds.)

This rapid increase in popularity was led by the introduction of more focused areas of investment, including single sectors (technology, energy, etc.), value or growth only, single countries and much more. These offerings have been dubbed factor funds.

This evolution has given investors, including Tanglewood, the ability to further define the criteria for both our equity and bond holdings. For example, one of our factor ETF holdings invests only in a “quality” subset of the S&P 500 index – those stocks that meet stringent earnings and balance sheet tests.

Until recently, the holdings within factor ETFs were held passively according to the criteria of the “factor”. Rebalancing is typically done on a set schedule, often annually.

The very latest innovation is actively managed ETFs. This removes the final major distinction between most mutual funds and ETFs. This brings truly active management into the low cost, tax efficient, transparent world of ETFs.

Two of the great managers that we have used in a mutual fund format have opened active ETF funds which we have invested in.

I have had a long enough career to have experienced each change along the way. It is incredibly satisfying to have the range of options and efficiencies of today’s marketplace.

Disclosures