One of our clients recently asked us if he was invested in the best exchange-traded funds. He readily accepts our investment management philosophy. He understands the importance of asset allocation, diversification, asset location (for tax efficiency), cost containment and rebalancing. But he knows we use a variety of funds to build client portfolios and he wanted to make certain that his portfolio included the “best” funds.

Let’s first review what an exchanged-traded fund (ETF) is. An ETF is a pooled investment vehicle. A sponsor creates an ETF by choosing a particular investment objective. The first ETFs were designed to follow an index, such as the Standard & Poor’s 500 Index. The SPDR S&P 500 ETF (ticker symbol: SPY) is an ETF that was created by State Street Global Advisors in 1993 to track this index of large US companies.

The sponsor then relies on “authorized participants” to create liquidity for the fund (We will forgo diving into the actual process).

There are now thousands of ETFs that track indexes or other baskets of stocks, bonds, commodities, and other securities. Investors buy and sell ETFs on an exchange through a broker. Springwater trades ETFs for our clients’ portfolios through Charles Schwab.

You might think that ETFs are like mutual funds, and they are, except that ETFs have additional characteristics that can make them attractive to active investors. It is possible to buy options on ETFs, short sell ETFs, place limit orders on ETFs and buy ETFs on margin. If those terms don’t mean anything to you, don’t worry. Springwater doesn’t use those trading strategies.

So why do we use ETFs, and why can they be useful to you as an investor? ETFs are an inexpensive way to invest. The SPY has an expense rate of 0.0945%. The expense ratio is the amount the sponsor (State Street Global Advisors in this case) charges to manage the fund. The average stock mutual fund has an expense ratio that is around 1.00%. The difference is enormous.

Exchange trade funds trade like stocks. The commission to buy and sell an ETF can be less than the commission to trade a similar mutual fund. Charles Schwab generally charges $5 to buy or sell an ETF. Schwab generally charges $25 to buy and sell a mutual fund. There are some ETFs (and mutual funds) that trade commission-free at Schwab.

ETFs are a tax-efficient way to invest. Because of the way exchange-traded funds are created and redeemed, they are more tax-efficient than most mutual funds. We find very little tax drag with the ETFs we use in our clients’ portfolios.

So, back to the question: What are the best ETFs? In our opinion, the “best” ETFs:

– provide good exposure to the asset classes in which you wish to invest
– have low expense ratios
– have low bid/ask spreads (the difference between the price at which you can buy and at which you can sell), and
– have low trading costs

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