All About Exchange Traded Funds (ETF) Part I
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By :
Andrew Shultz
Submitted
2010-07-31 12:15:11 |
ETFs or exchange-traded-funds are portfolios of stocks and/or bonds that offer greater transparency, lower fees and more tax efficiency than your regular mutual funds. ETFs are also a great investment vehicle for people who can't tolerate higher risk. For example, owning an ETF that tracks S&P 500 index is less risky proposition than placing a bet on one or two S&P 500 stocks.
There are ETFs that track major and minor stock indexes, individual sectors and even bond indexes. Like conventional index investments, ETFs allow investors to be as active or passive as they wish. You can build your entire portfolio using index ETFs that offer broad exposure to stocks and bonds. More-sophisticated investors might instead choose to cobble together portfolios based on a dozen or more sector ETFs. In recent times, equity and bond markets have shown a high level of volatility and thus even investment-grade bonds can quickly turn sour. This makes ETFs more attractive. Moreover, fixed-income ETFs involve a certain level of professional management in monitoring bonds' credit quality and ensuring that target maturities are maintained.
ETFs have one very distinct difference when compared to traditional index funds. ETFs can be bought and sold throughout the trading day at intra day prices, rather than based on a fund's net asset value at 4 p.m. (Eastern time) on any given day. This might not matter much to long-term investors who evaluate their portfolios over periods of years rather than hours — but it can be a big advantage for traders. Sometimes stock prices in a certain sector, such as energy can have a intra day swing of 5% or more and ETFs can be good options if you're looking for very short term trades. In summary, think of ETFs as mutual funds that can be bought and sold just like stocks.
As you have found out, ETFs offer you all the flexibility of stocks: They're priced throughout the day; can be purchased with market, limit or stop-loss orders; can be shorted; and can be traded on margin. And as with stocks but unlike mutual funds, there are put and call options based on many of them. If you are familiar with options and trade options, that can be an added advantage. Also, ETFs are passively managed and don't have much asset turnover, so their expense ratios are far lower than those of even the most cost-efficient actively managed funds such as Fidelity. They're even lower than those of most passively managed index funds. For example, the first-ever ETF, Standard & Poor's Depositary Receipts (SPY), known as Spiders, carry a lean and mean expense ratio of 0.11%.
One of the important thing to keep in mind is that index ETFs don't always outperform their index mutual fund counterparts. For example, from 1994 to 2002, Spiders, which track the S&P 500, delivered a cumulative return of 119.52%, a hair shy of the Vanguard 500 Index's 120.69% gain. Why the discrepancy? ETFs tend to be even more passive in implementing index changes than their mutual fund competitors. But some ETFs are nimbler than others. One of the biggest selling point for ETFs is their tax efficiency, which can be substantial. Because of their structure, ETFs protect shareholders from the downside of investor churn: Capital gains distributions aren't triggered for every investor whenever a position is sold — a boon come tax time. Of course, if an individual investor sells an ETF and realizes a gain, it will be taxable. But while incremental trading costs are the collective responsibility of most mutual funds' shareholders (and arguably borne to a greater extent by long-term investors), ETF investors simply pay their own way.
That doesn't mean, however, that capital gains are never an issue. Back in 2000, when the major indexes touched all-time highs and then plummeted, mutual funds of all types were forced to unload stocks as investors bailed out, triggering capital gains bills for the investors who hung on, even as ETF values fell. In that year, 27 ETFs (about a third) issued capital gains. But increasingly sophisticated techniques to manage distributions have kept a lid on distributions more recently. For example, Spiders haven't distributed capital gains since 1996.
Continue to Read ETF Part II
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Article From Fiscalwealth | Personal Finances, Investment and Wealth Management
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