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 Exchange Traded Funds or ETFs
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.
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The biggest drawback for ETFs is transaction costs. The only way to buy or sell an ETF is via a broker — and for fast-fingered traders, the costs can add up. That's why fans of dollar-cost averaging might find ETFs to be a pricey endeavor. If you're willing to handle the trading cost and manage your own online trading through a discount online broker, this may not be as big of an issue.
IN TERMS OF net assets, Standard & Poor's Depositary Receipts (SPY), or Spiders, are by far the biggest ETFs. Launched in 1993 by State Street Global Advisors, they now boast more than $41 billion in assets (as of Apr. 2, 2004). Next come the Nasdaq-100 Index Tracking Stock (QQQQ), commonly referred to as Qubes.
One of the greatest advantages of ETFs is the ability to allow broad-based index products. especially appealing to buy-and-hold investors. More-active traders might consider sector-based ETFs. For example, Energy sector has been real hot with crude oil prices touching $100/b. If you have no clue what stock you need to own to get benefit from energy sector, you can just go out and purchase an energy ETF. For those who want to add some real estate to their portfolios, a real estate investment trust ETF might be a prudent move. A health care professional with large holdings of health care stocks might buy a put option on a health care sector ETF to minimize risk.
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 Final Verdict
As financial markets become more mature and get more active participation from individual investors, there will be a much broader selection of ETF offerings in the U.S. Products that track commodities, currencies or even gold ETFs. And ETFs that track crude oil or nonferrous metals could start cropping up too.
As ETF offerings blossom, investors will surely call on increasingly sophisticated strategies to exploit them. Hedge funds will likely be the pioneers. Right now, most of them use ETFs both to maximize gains and to minimize risk. A common tactic is to play a single stock off its industry group. Say a hedge-fund manager thinks CSCO will outperform its peers. He'd buy CISCO (CSCO) and short-sell an ETF that tracks the networking sector. The same sort of long/short strategy can be executed with put and call options as well. And that's just the beginning.
In the fixed-income arena, the benefits of ETFs are even clearer. The performance difference between similar bonds typically isn't all that large; usually, it comes down to transaction fees. Buying a single fixed-income ETF is more cost-efficient — and is far easier — than laddering different notes of varying maturities.
In a rising interest-rate environment, bonds of shorter durations are generally the vehicle of choice. The idea is to hold short-maturity bonds so that when interest rates rise, new bonds with higher coupons can be purchased. If investors are locked into longer-maturity bonds, they'll be at a disadvantage when rates rise and bonds with higher coupons are offered: Not only will their money be earning less than it could, but buyers for bonds offering lesser coupons are often scarce. So experts say the name of the game now is to go short-duration.
Remember, purchasing shorter-maturity bonds in a low-cost way plays perfectly into ETFs' strengths because the shorter the bond duration, the more efficient the market tends to be. So using an actively managed short-term bond fund is less necessary than, say, a managed fund for municipals or high-yield bonds, which have less efficient markets. If you agree with the prevailing view that the next move for interest rates is higher, purchasing shorter-duration fixed-income ETFs can provide bond exposure and minimize interest-rate risk. An even more aggressive play is to short-sell a longer-maturity ETF, such as iShares Lehman 20+ Year Treasury Bond Fund (TLT). Typically, the longer the bond duration, the greater the price movement. So shorting longer-duration bonds in a rising interest-rate environment can translate into greater gains for investors. But this obviously carries more risk.
Increasingly, fixed-income ETFs also are being used as alternatives to money markets, experts say. With money-market funds offering paltry yields, investors can squeeze out better returns by assuming a bit more risk with shorter-duration fixed-income ETFs. Consider that the iShares Lehman 1-3 Year Treasury Bond Fund (SHY) carries a yield of 1.75%, far surpassing the average taxable money-market yield of 0.50%.
While bonds may not seem sexy, fixed-income ETFs can add just the right amount of spice to a portfolio.
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