Exchange-traded funds (ETFs) are growing more popular by the week, and financial experts claim this is not just a passing trend.  ETFs were not introduced until the early 1990s,  and failed to gain widespread acceptance until the last five or six years.  Today, U.S. ETF assets exceed $750 billion.   While traditional mutual funds have been around a  long time and have established strong reputations as predominant portfolio standards the rapid growth of ETF assets have the potential to pass total mutual fund assets soon, and in a big way.

Both types of funds cover an expanded range of  investment styles and stock market segments.   Because of index tracking, both types of funds have overall low operating expenses compared with active funds.  However, there are numerous and material differences based on their completely different designs and views toward the various financial markets.  Upon closer examination, ETFs look better all the time.  However, because they do share some similar characteristics, inexperienced investors sometimes have difficulties understanding how the two types of mutual funds are different.

Both mutual funds and ETFs seek to closely track a benchmark, but only 15% of traditional mutual funds will ever exceed it.  The composition and construction of an index are important factors that affect ETF performance.  With an ETF tracking, the index will usually be made up of the same stocks in the same proportion. The goal of an index ETF is to match the performance of the index as closely as possible, not to out-perform it. The narrower the spread, the closer the fund is to achieving this goal.

ETFs have a unique structure that gives them a distinct advantage over traditional mutual funds.  With traditional funds, investors purchase their shares from a financial company and sell them back once they are ready to redeem them.   ETF shares, on the other hand, are  traded with other market investors much in the same way as stocks are traded.  ETFs are traded and priced on the American, NASDAQ and  New York Stock Exchanges.  Conventional mutual fund prices are set once daily and investors are forced to place their orders prior to that time to get that day’s price.

ETFs have an advantage over traditional mutual funds in that they do not require a minimum investment.  Investors can even purchase one share, if they so desire.  The majority of mutual funds, however, require a minimum investment that can run as high as $50K.   Another advantage of buying into ETFs is that they can be sold short, which allows investors to bet on a lower index that is tracked by the fund.  With mutual funds investing, either the investor buys one or not.  ETFs open an entire broad range of investing possibilities.

There is compelling evidence to suggest that ETFs stand to gain the reputation as the future of investing.  New trends show that investor assets are shifting from traditional mutual funds into ETFs.  For each $100 that was invested in the year 2001, 90% of it went into conventional mutual funds.  Approximately $8 was put into index funds and the remaining $2 went into ETFs.  Seven years later, the share of conventional mutual funds went down to about $82.  Index funds rose to $10 and ETFs rose to $9.  This is a telling trend.

Major search engine trends point to the fact that the term, “mutual funds,” is being searched for less than the term, “ETF.”  This is a significant point given the fact that search volume is considered to be tantamount to relevance in the world of finance.  This is a definite indicator that ETFs are growing significantly in popularity.  Additionally, a lot of the major brokerage firms such as Forbes and Charles Schwab are looking to ETFs for their clients as top investment transporters.

The whole reason for the trends toward increased buying is simple.  ETFs clearly outperform mutual funds.  Granted, the mutual fund industry is not going away any time soon.  This time of fund management will always have a place in the finance industry.  However, the efficiency, convenience and performance of  exchange-traded funds will cause them to grow and probably very quickly overcome less-useful financial alternatives.  This is good news for investors everywhere.  There are ETFs for small companies, real estate, large US companies, international stocks and even gold.  Virtually any asset class that is currently available to the public is probably represented by an ETF or will be in the near future.

ETFs are both economical to maintain and to buy, so they are particularly attractive to the buy-and-hold investor or the person who does not do a lot of trading.  Fees as low as .09% of assets make them much lower than the average traditional mutual fund fees that stand at around 1.4%.  While investors do have to pay a brokerage fee to purchase ETFs, the fee becomes negligible with larger trades.   Tax effects should be given mention and ETFs give outstanding performance after taxes.

Anyone who is interested in buying ETFs would be well served to study the philosophy of index trading and investing because ETFs share the view that stock picking is not as important as buying the market.  However, unlike index funds, investors do not have to take the same passive approach.  ETFs are now being favored by hedge funds and day traders as well.  Both of these investors can lower overall transaction costs and in doing so, can strengthen one another.

In the past, the brokerage fees for ETFs were prohibitively high.  However, in recent years, this has changed.  There are now ultra low-cost brokerages, or those who don’t charge at all.  Therefore, many people are jumping on the ETF bandwagon to take advantage of the cost efficiency of making small, frequent purchases of ETF shares.

Options are only one of the advanced trading possibilities available for ETFs.  These investments give investors the right to “put” or “call” (buy or sell) ETF shares for a specific price at some point in the future.