There has been a rapid proliferation of ETFs. They come in all sorts of flavors to track specific niches. While it is clear what the large ETF index funds contain it is not always so with some of the new ones.
For example, I know that a S&P 500 Spyder has all 500 of the S&P stocks in the trust the shares trade against. But if someone sells me a sector index fund I can't be so sure. Because there isn't a universally agreed list of what companies comprise which sectors, you may get 20 companies in one sector ETF while another ETF in the same sector only has 8.
That is one more reason why it is important to read the prospectus for any ETF you buy. You need to know what the trust holds and how much it really diversifies your portfolio. Don't be surprised, do your homework.
ETF's (Exchange Traded Funds): What They Are & How They Work
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Exchange-traded funds, or ETFs, have been attracting more and more attention from investors in recent years. In fact, assets in ETFs have more than doubled, rising from $133 billion in November 2003 to $289 billion in November 2005, according to the Investment Company Institute.
In this commentary, you will find some answers to common questions about ETFs, learn how they compare with and differ from conventional mutual funds, and gain a better understanding of why your advisor may be using them in your investment portfolio.
What is an ETF?
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Simply put, an ETF is a type of investment that is like both a mutual fund and an individual stock. Exchange Traded Funds are a class of equity vehicles commonly referred to as ETFs. ETFs are baskets of equities, similar to mutual funds, that trade much more like stocks. A mutual fund is managed by a portfolio manager and you don't often know what equities are held, or in what proportions they have been purchased. ETFs, on the other hand, are transparent in the sense that the investor always have access to the holdings within any ETF product. With an ETF, the basket of stocks are designed to closely mirror the movement of an index, such as the S&P 500. Unlike mutual funds, ETFs can be purchased and sold throughout the course of a day, stop and limit orders can be placed on them, they can be sold short, and they may also be margined. There are hundreds of ETFs now available, tracking a myriad of different market and sector indices. Some of the different indices tracked by ETFs include the following:
* General Market Indices (e.g. S&P 500, S&P Small cap 600 index)
* Sector Indices (e.g. Dow Jones Energy Sector, NASDAQ Biotech Sector)
* Fixed Income Indices (e.g. Lehman 20+ Year Treasury Bond Fund)
* Inernational Indices (e.g. S&P Latin America 40 Index, Emerging Markets
ETF Names
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There are a number of different companies that sponsor a particular brand of Exchange Traded Funds. While the category of ETFs combines all securities of this type, there are several different "classes," much the same as there are several different mutual fund families. Some of the most popular ETF classes are:
iShares
VIPERs
HOLDRs
SPDR
streetTRACKS
PowerShares
The traits of mutual funds
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Like mutual funds, ETFs offer investors a proportionate share in a professionally managed, generally diversified portfolio of securities, such as stocks or bonds. They can cover a wide range of industry sectors and investment styles. And virtually all are indexed portfolios, meaning they seek to closely track the performance of industry-accepted market indexes. Thus, many ETFs offer the advantages of traditional indexed mutual funds, such as low operating costs and the potential for high tax efficiency.
The flexibility of stocks
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Like stocks, ETFs are listed on major security exchanges, such as the New York Stock Exchange and the American Stock Exchange. They are bought and sold by retail investors on the open market through brokerage firms.
Like stocks, ETFs are also subject to tradional stock market risks and rewards. As shares in a portfolio of stocks, the value of ETF shares will rise and fall as the stock market fluctuates, causing the ETF to gain or lose value over short or over long periods of time.
ETFs also offer trading flexibility -- their biggest difference from conventional mutual funds. Their shares can be traded whenever the exchanges are open, at up-to-the-minute prices, and in a variety of ways.
How do ETFs work?
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In spite of their similarities, mutual funds and ETFs work quite differently.
The mutual fund approach
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In a mutual fund, most transactions are conducted with cash. With rare exceptions, investors purchasing fund shares pay cash to the fund, while those redeeming shares receive cash from the fund, possibly requiring the fund manager to buy or sell securities in the portfolio. When the fund trades securities, it incurs transaction costs such as brokerage commissions and, in some cases, realizes capital gains on which shareholders will owe tax.
The ETF difference
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An ETF, by contrast, does not generally experience cash flows into or out of the fund. Only certain sophisticated institutional investors (a brokerage house, for example) are authorized to purchase or redeem securities directly with an ETF, and they do so almost exclusively with securities. When these institutional investors purchase shares of an ETF, they give the fund specific quantities of securities that are part of the index the ETF tracks. Similarly, when these institutions redeem their ETF shares, the ETF will provide them with securities, not cash. These cashless transactions benefit the fund in two ways: They do not cause the fund to incur transaction costs, and they do not cause the fund to realize taxable capital gains.
Institutional investors sell their ETF shares to retail investors on the open market, who may then trade shares for cash with other retail investors. These market trades, however, have no effect on the ETF itself; no cash goes into or out of the fund that would require it to purchase or sell portfolio securities, pay brokerage commissions, and possibly realize capital gains. As a result, the ETF is largely able to hold down its operating costs and limit the distribution of taxable gains to shareholders.
Enhancing portfolio flexibility
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For investment purposes, ETFs are not categorically superior to mutual funds, or vice versa. ETFs are essentially just another type of indexed investment; they can be used as part of a long-term asset allocation strategy, just as index mutual funds can be. However, the structure of ETFs gives them much greater trading flexibility than conventional funds -- flexibility that may make them more suitable for your advisor in managing your individual portfolio.
How are ETFs traded?
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As you may know, orders to buy or sell mutual fund shares can be placed with the investment management company at any time. However, the fund shares are priced just once a day, at the close of the New York Stock Exchange, and transactions are executed at the fund's daily closing price.
Trade almost anytime
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ETFs, on the other hand, can be bought and sold anytime through a brokerage account during stock exchange hours. Their shares are priced and repriced throughout the day; therefore, their value fluctuates from minute to minute. Plus, because they are offered on an exchange and through a broker, ETFs can be traded using the same techniques typically associated with individual stocks.
The importance of flexibility
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Why is flexibility important? It gives your advisor the ability to execute specific asset management strategies in your portfolio aimed at meeting your investment objectives. For example, your advisor can place a stop-loss order on ETF shares, which is an order to sell the shares if prices fall to or below a predetermined level. He or she could sell ETF shares short to hedge the risk of other investments you hold, or shift assets out of and back into an ETF on a short-term basis to realize capital losses and better manage your tax liability. This technique and others are more difficult with conventional mutual fund shares and are not always as effective.
Your advisor uses ETFs in many ways:
* To serve as core holdings for your long-term investment strategy.
* To hedge the risk of other investments, such as company stock.
* To execute strategies designed to reduce tax liability.
* To put unexpected cash windfalls to work quickly in the market.
What else should you know?
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Here are some other points to keep in mind about ETFs:
ETFs are priced by the market
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The prices of the securities held by an underlying ETF, as well as supply and demand in the market, determine the price of its shares.
The market price of an ETF share at any given moment may be above or below the net asset value of the underlying securities held by the ETF. The difference between the price and value typically is small, but this difference can be significant in periods of extreme market volatility.
ETFs have low operating expenses
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As with any investment product, operating costs vary from ETF to ETF. Generally, however, these costs are low. Because retail ETF investors place transactions through brokerage firms, the underlying funds do not incur additional administrative costs that mutual funds do for items such as telephone call centers, correspondence, postage, and account recordkeeping.
Some ETFs have expense ratios below those of comparable index funds. Others, however -- typically those that target industry sectors or international markets -- can have much higher expense ratios.
ETFs incur retail transaction costs
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When your advisor buys or sells ETF shares for your portfolio, you will incur brokerage commissions. ETF market prices also are affected by bid-ask spreads -- the difference between what a dealer will pay for a security it buys from one retail investor and the somewhat higher price at which the dealer will sell the same security to another. Like any other investment costs, these costs are borne by you, the individual investor, and can affect your investment returns.
ETFs are tax-efficient, not tax-free
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ETFs are not tax-free, a common misperception among investors.
Like mutual funds, ETFs must annually distribute any taxable income and capital gains to shareholders. Though distributions of capital gains happen relatively infrequently, nearly all ETFs have distributed taxable gains at some point.
ETFs based on indexed portfolios typically follow a buy-and-hold investment strategy, so they are generally more tax-efficient than actively managed mutual funds. However, tax efficiency depends largely on how much the components of the ETF's underlying index change over time. As mentioned previously, when an index's composition changes, an ETF must buy or sell holdings to match the changes, which can produce taxable capital gains that will be distributed to shareholders.
ETFs are suited to many purposes
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ETFs are available to track indexes for a wide range of investment styles, market segments, industry sectors, and geographical regions. Like any investment, they are not suited for everyone or for every purpose. For example, the transaction costs associated with ETFs make them less appropriate for small purchases or investing a fixed amount in a particular fund on regular intervals (modified dollar cost averaging).
ETFs stack up pretty well against other types of investments. They share many of the qualities of index funds that can make them choice investment vehicles: diversification, cost-effectiveness, potential tax efficiency, and transparency. Their trading flexibility also makes them suitable for your advisor to execute a variety of portfolio-management strategies aimed at helping you achieve your financial goals. To better understand how ETFs can be used in your portfolio to help meet your financial goals, talk with your financial advisor.
Posted by: Bob Hansell | August 21, 2006 10:14 PM | Permalink to Comment