Exchange Traded Funds (EFT)

What is exchange traded funds?

Exchange traded funds are collective investment vehicles which track indices - they can allow low cost exposure to the performance of an index as quickly and efficiently as the most liquid stocks.
Exchange traded funds (ETFs) are listed on an exchange and can be traded intraday. Investors can buy or sell shares in the collective performance of an entire stock or bond portfolio as a single security. Exchange traded funds add the flexibility, ease, and liquidity of stock trading to the benefits of traditional index fund investing.

Exchange-traded funds (ETFs) popularity

Exchange-traded funds (ETFs) are increasing in popularity, as they are often responsible for approximately 50% of the daily trade volume on the American Stock Exchange (AMEX). ETFs are passive funds that track their related index and have the flexibility of trading like a security. They are managed by professionals and provide the investor with diversification, cost and tax efficiency, liquidity, marginability, are useful for hedging, have the ability to go long and short, and some even provide quarterly dividends.

ETFs are unit investment trusts (UITs) that have two markets. The primary market is where institutions swap "creation units" in block-multiples of 50,000 shares for in-kind securities and cash in the form of dividends. The secondary market is where individual investors can trade as little as a single share during trading hours on the exchange. This is different from open-end mutual funds that are traded after hours once the net asset value (NAV) is calculated.

The most widely traded and well-known ETF is the SPDR (pronounced spider, Standard and Poor's Depository Receipt). Other ETFs include Diamonds (Dow Jones Industrial Average), Qubes (Nasdaq-100 Index Tracking Stock) named after the ticker, QQQ, and Webs (World Equity Benchmark Shares). Webs mirror indices in foreign equity markets. There are currently 30 ETFs available on the AMEX and they include 17 Webs, 11 SPDRs (includes sectors), and one Qube and one Diamond.

The American Stock Exchange lists ETFs on more than 100 broad stock market, stock industry sector, international stock, and U.S. Treasury, and corporate bond indexes, providing a wide array of investment opportunities. ETFs provide a simple and effective way to invest in equity markets worldwide and the U.S. bond market. Investors can establish long-term investments in the market performance of the leading companies in the leading industries in the United States or abroad, or tailor asset allocations using diversified investments in stocks in particular industries or countries or in U.S. bonds.

Why Exchange Traded Funds?

Exchange-Traded Funds, or ETFs, are index funds that trade just like stocks on major stock exchanges. Want to invest in the market quickly and cheaply? ETFs are the most practical vehicle. They help the investor focus on what is most important, choice of asset classes.

All the major stock indexes have ETFs based on them, including:

Dow Jones Industrial Average
Standard & Poor's 500 Index
NASDAQ Composite

There are ETFs for large US companies, small ones, real estate investment trusts, international stocks, bonds, and even gold. Pick an asset class that is publicly available and there is a good bet that it is represented by an ETF or will be soon.

ETFs differ fundamentally from traditional mutual funds, which do not trade midday. Traditional mutual funds take orders during Wall Street trading hours, but the transactions actually occur at the close of the market. The price they receive is the sum of the closing day prices of all the stocks contained in the fund. Not so for ETFs, which trade instantaneously all day long and allow an investor to lock in a price for the underlying stocks immediately.

ETFs are economical to buy and especially to maintain over the long-run, making them especially attractive for the typical buy-and-hold investor. Annual fees are as low as .09% of assets, which is breathtakingly low compared to the average mutual fund fees of 1.4%. Although investors must pay a brokerage transaction to purchase them, with discount brokers this becomes negligible with sizable trades. There are a few easy-to-avoid pitfalls to watch out for. Tax effects are also not to be ignored, and ETFs perform well after-tax. They can be margined, and options based on them allow for various defensive (or speculative) investing strategies.

Their safety as a securities instrument (considered separately from the safety of any particular asset class they might represent) is considered the same as stock certificates themselves. Internally, ETFs are far more complex entities than mutual funds. A fascinating combination of players, including brokers, money managers and market specialists combine to make them run smoothly. Legally, ETFs are a class of mutual fund as they fall under many of the same Securities Exchange Commission rules that traditional mutual funds do. But their different structure means that the SEC has imposed different requirements from traditional mutual funds in how they are bought and sold.

ETFs are index funds at heart, so investors are encouraged to study the philosophy of index investing which downplays stock picking in favor of buying the market. But unlike most traditional index funds, investors need not take a passive, buy-and-hold approach. ETFs are also becoming favorites of hedge funds and day traders who like to pull the trigger frequently. Both types of investors may coexist and in fact strengthen each other by lowering overall transaction costs.

The advantages of ETFs:

Tax efficiency
ETFs, like index funds in general, tend to offer greater tax benefits because they generate fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell securities to meet investor cash redemptions, potentially generating capital gains tax liability for remaining investors. Keep in mind that the sale of an ETF will generate capital gains/losses for the investor liquidating shares.

As luck would have it ETFs are also quite tax-efficient. Because of the way they are created and redeemed, they allow an investor to pay most of his capital gains upon final sale of the ETF, delaying it until the very end. There is no way to avoid capital gains, but delaying it is valuable because the amount that would have been paid to taxes can continue to accumulate wealth. Exactly how much an investor benefits after-tax depends on their marginal tax rate, the return of the investment, and how long they hold the investment. Overall, ETFs are similar to tax managed index mutual funds, slightly more efficient than standard mutual funds, and significantly more efficient than actively managed mutual funds.

Traditional mutual funds accumulate unrealized capital gains liabilities for stocks that have risen in value. Upon sale of these stocks the fund calculates and periodically distributes the capital gains to its investors in proportion to their ownership. The following table illustrates a comparison of ETFs versus standard index mutual funds:

Lower costs (ordinary brokerage commissions apply)

Expenses can have a significant impact on returns for investors. ETFs, in general, have significantly lower annual expense ratios than other investment products. ETFs are less likely to experience high management fees because they are index-based, not "actively" managed. And, since they trade on an exchange, ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. Of course, an investor selling ETF shares may realize capital gains or losses, as with common stocks. Purchases or sales of exchange traded funds are subject to brokerage commissions

Most open-end index funds can be purchased directly from their distributors without a transaction fee. Those bought through the discount brokers like Charles Schwab or E*Trade usually include a transaction charge of $15-$30 or more. Exchange-traded funds, on the other hand, are subject to regular brokerage commissions on all purchases and sales. An additional cost to investors in ETFs is the "spread" between the bid and ask price. This can amount to over 1% of the purchase or sale price.

Expense ratios (ER) are very similar among ETFs and open-end index funds. However, there is often an additional cost of ownership to holding ETFs. SPDRs, for example, pay dividends quarterly directly to investors. An open-end index fund like the Vanguard 500 Index reinvests dividends into new shares as they are paid. The delay of dividend reinvestment with ETFs is often referred to as "dividend drag."

Transparency

ETFs are designed to generally replicate the holdings and correspond to the performance and yield of their underlying index

Buying and selling flexibility
Because they are exchange traded, ETFs can be:

bought and sold at intraday market prices
purchased on margin
sold short, even on a downtick (unlike common stocks)
traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade
All day tracking and trading
ETFs are priced and traded throughout the day, and are not restricted to once-a-day trading at the end of the day. And because the pricing of ETFs is continuous during trading hours, investors will always be able to obtain up-to-the-minute share prices from their broker or financial adviser.
Diversification
Because each ETF is comprised of a basket of securities, it inherently provides diversification across an entire index. Additionally, the expanding universe of ETFs available offers exposure to a diverse variety of markets, including:

broad-based equity indexes (such as total market, large-cap growth, and small-cap value)
broad-based international and country-specific equity indexes (such as Europe, EAFE, and Japan)
industry sector-specific equity indexes (such as healthcare, energy, and real estate) ü U.S. bond indexes (such as long-term Treasury bonds and corporate bonds)

Dividend opportunities
Dividends paid by companies and interest paid on bonds held in an ETF are distributed to ETF holders, less expenses, on a pro rata basis. Of course, not all companies will pay dividends. Based on past performance, few, if any, distributions can be expected from certain ETFs. There may also be opportunities for reinvestment of distributions.
Wide array of investment strategies
Investors can capitalize on the convenience and flexibility of ETFs to pursue a wide variety of investment strategies.
Core investment
Investors can use ETFs as a core investment for their portfolio. The purchase of shares in a single ETF can provide broad market exposure of a portfolio of stocks or bonds for long-term holding that is easy to establish, easy to track, inexpensive, and tax efficient.
Portfolio diversification
Portfolio diversification—ETFs cover virtually every segment of the equity market and several segments of the U.S. bond market, providing an easy and convenient way to adjust the investment mix of a core portfolio.
Hedging
Hedging—Exchange traded funds can be purchased on margin and sold short (even on a downtick), which has opened up risk management strategies for individual investors that were once available only to large institutions. For example, ETFs can be sold short to hedge a core stock portfolio or interest rate fluctuations. This allows investors to keep their portfolio intact while protecting them from market losses. In a declining stock market or rising interest rate environment, profits from a short position can offset some of the losses in a portfolio. (Investors are required to make arrangements to borrow securities before selling short.) Listed options, available on some ETFs, also offer opportunities for additional hedging or to increase income. Investors should contact their broker regarding initial and maintenance margin requirements.
Cash management
Cash management—ETFs have often been used to "equitize" cash, providing a way for investors to put cash to work in the market or maintain allocation targets while determining where to invest for the longer term.
Rebalancing
Rebalancing—Investors can adjust ETF positions at any time throughout the trading day, without redemption fees or short-term restrictions. Again, usual brokerage commissions will apply.
Tax loss strategy
Tax loss strategy—An investor can sell a security that is underperforming and claim a tax loss but retain exposure to its sector by investing in an ETF. Consult a tax advisor about a tax loss strategy.
Risks and other considerations
Risks and other considerations ETF shareholders are subject to risks similar to those of holders of other diversified portfolios. A primary consideration is that the general level of stock or bond prices may decline, thus affecting the value of an equity or fixed income exchange traded fund, respectively. This is because an equity (or bond) ETF represents interest in a portfolio of stocks (or bonds). When interest rates rise, bond prices generally will decline, which will adversely affect the value of fixed income ETFs. Moreover, the overall depth and liquidity of the secondary market may also fluctuate.
An exchange traded sector fund may also be adversely affected by the performance of that specific sector or group of industries on which it is based.
International investments may involve risk of capital loss from unfavorable fluctuations in currency values, differences in generally accepted accounting principles, or economic, political instability in other nations.
Although exchange traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the trusts may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors.