Understanding ETFs

An exchange-traded fund (ETF) is a closed-end investment in stocks and bonds, which is purchased on an exchange and represents ownership in a basket of securities. ETFs are passively managed funds that mirror a specified index through a pre-specified group of stocks and they typically focus on U.S. and international stocks, bonds, currencies, commodities, and precious metals as incorporated in the S&P 500 (SPDRs), value and growth sectors such as energy (SPDR Energy, S&P/Barra Growth Index Fund), countries (MSCI-Taiwan) or regions (MSCI-EAFE).

The use of passively managed funds matches the performance of the aggregate market by reflecting the composition and the performance of selected market index series. When portfolio managers decide that they want a given asset class in their portfolio, they look for ETFs to fulfil this need. The use of ETFs is less costly in terms of research and trading and they can always provide the same or better performance than what is available from the majority of actively managed funds. In this context, ETFs are a good solution for portfolio diversification because investors acquire certain securities, which they can trade like individual stocks. ETFs are bought and sold at the market price anytime during a trading session and therefore they are a flexible and low cost way to invest.

The fact that ETFs follow indexes gives investors the opportunity to get exposure in the market. ETFs trade throughout the day in large blocks of 50,000 stocks, unlike index mutual funds that are purchased or sold by investors once a day. Being traded like stocks, ETFs are attractive to market-timer investors, who wish to trade certain indices that are not easily available in the stock market. Also, there are ETFs based on fundamental indexing, which track stocks that are weighted by their earnings, dividends or cash flows, rather than by market capitalization. These ETFs may offer investors better long-term performance.

The types of ETFS that are currently available to investors are:

a/ Diamonds Trust Series I (DIAMONDs) tracking Dow Jones Industrial Average Index

b/ Fixed income exchange traded securities (FITRs) tracking various treasuries

c/ Holding company depository receipts (HOLDRs) tracking narrow industry groups.

d/ Shares - possibly "index shares" (iShares) tracking Group of ETFs marketed by Barclays Global Investors

e/ Nasdaq-100 tracking stock (QUBEs) tracking Nasdaq-100 index

f/ Standard & Poors' Depository Receipts (SPDRs) tracking a variety of S&P indexes

g/ State Street Global Advisor ETFs (StreetTracks) tracking various indexes, including Dow Jones style indexes and Wilshire indexes.

h/ Vanguard Index Participation Receipts (VIPERs) tracking several Vanguard index funds

Unlike close-end funds, ETFs keep their market price close to the net asset value (NAV) because large institutional investors assemble baskets of the underlying stocks and exchange them for ETF shares if the ETF sells in a higher price than the funds’ net asset value. Similarly, if the ETF sells in a lower price than the funds’ net asset value, investors buy ETF shares and convert them to the underlying security. However, this means that an ETF might not mirror the specified index accurately and could potentially trade above or below the net asset value of the underlying portfolio.

ETFs are more efficient than traditional mutual funds because they are not continuously issuing securities in order to maintain liquidity positions. Therefore, they have lower expenses than typical closed-end funds. On the other hand, brokerage commissions increase the trading cost of ETFs and if there are frequent purchases planned, they are not a good vehicle to get exposure on the market.

ETFs are significantly tax efficient due to Security & Exchange Commission (SEC) regulations. The fact that ETFS are constructed in individual units allows fund managers to sell on behalf of one investor without triggering capital gains for another. On the other hand, since several ETFs do not trade frequently it makes it difficult for the investor to exit an investment or make a quick purchase.

According to Morningstar, the average expense ratio for U.S.-listed ETFs is 0.4%, while for diversified U.S. stock funds reaches 1.42%. However, commission charged from the brokerage firm may reach $10 per trade which equals 1% fee on a $1,000 ETF trade. Therefore, an investor, who buys and sells frequently, may end up paying more money than if, he had bought a similar commission-free mutual fund. So, ETFs are cheap to own, but may be expensive to trade.