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ETFs Avoid the Expense of Fund Managers

Most open-end mutual funds (which will be referred to simply as mutual funds throughout the rest of the book) are actively managed. This means that most funds have managers who pick which stocks to buy and sell, and when, according to their own judgments. Active managers generally keep their stock selections secret until they have finished making transactions for their own funds. In this way, they avoid having to compete in the market when placing transactions against free riders, who might want to copy the managers' ideas.

In contrast, ETFs are passively managed. Passive management means that a predetermined set of rules is used to select the individual stocks that are held in each ETF. An ETF sponsor can update the selection of stocks in a passively managed portfolio, but only on dates that it specified in advance. Anybody who knows what the rules are can anticipate the changes that an ETF will be making to its portfolio on the dates specified for portfolio update. Because the rules for selecting a passively managed portfolio are available to everyone, it is unnecessary to hire a manager.

The fund sponsor for each passively managed ETF selects a set of rules that govern which stocks the ETF will hold. After these rules are in place, the ETF does not deviate. So, unlike the case with an actively managed fund, investors in a passively managed fund or ETF know at any time exactly which stocks are in the fund and when that portfolio is scheduled to change. (Although some actively managed ETFs are in development, passively managed ETFs are likely to dominate the landscape for the foreseeable future.) The accurate knowledge by individual fund investors of their funds' holdings is called investment transparency. For many investors, this transparency is considered an advantage, because when you buy an ETF, you know exactly what you are getting.2

Another term used to describe passive investment management is indexing. The connotation of a market index, in addition to being passively managed and enjoying the attendant advantages of low cost and transparency, is that it usually aims to represent the performance of a particular market sector. Broadly based indexes can represent the entire universe of publicly traded shares in the United States, or even in the world (such as the MSCI World Index). At the other end of the spectrum, a number of market indexes have been designed to represent the behavior of fairly narrow industry sectors, such as the S&P Select Homebuilders Industry Index. (The latter is tracked by an ETF, the SPDR Homebuilders ETF, whose ticker symbol is XHB.)

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