Exchange Traded Funds 101

So, you've got a couple of bucks to invest. Maybe you have put some money into your IRA, or your 401k gives you a wide range of investment choices. Maybe you have money in the bank that is in excess of any emergency needs you have and you would like to get it working harder for you. If so, it is time to learn about ETFs.

I'm often surprised how many individuals who come to see me are not familiar with Exchange Traded Funds. These have become one of the most important products available to the general public and anyone who wants to invest should know what they are and understand them.

First a little history: ETFs had their beginning in 1989 with a"stock-like" product that attempted to match the performance of the S&P 500. This product ran into patent problems and sales were stopped in the United States. Another product was offered on the Toronto Exchange in 1990 and became so popular it led the American Stock Exchange to develop something that would satisfy SEC regulation in the United States.

Thus SPDRs or "Spiders" (which stands for Standard & Poor's Depositary Receipts,symbol SPY) were born in January 1993, becoming the largest ETF in the world.

Next, were borne the MidCap SPDRs and the race began to create a new industry. Barclays entered the fight in 1996 with WEBS--- World Equity Benchmark Shares, which became iSharesMSCI Index Fund Shares. WEBS tracked 17 country indexes which was an innovative way for the world to access foreign share inexpensively and easily.

In 1998, State Street introduced "Sector Spiders", which followed the nine sectors of the S&P 500and in 1998; the "Dow Diamonds" were introduced, tracking the Dow Jones Industrials Average. In 1999, the "cubes" or QQQ's (now QQQQ) were introduced to replicate the movement of the NASDAQ-100. Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes amounting to over 1 Trillion dollars invested.

Before we delve deeper into ETFs, we should learn a little more about indexes. An index is a list of financial instruments put together in order to track a particular market. For example, the Dow Jones Industrial Average is an index which tracks the performance of 30 large publicly owned companies traded in the stock market.

Any mutual fund investing in these 30 stocks would therefore be called an index fund. The one and only aim would be to give an investor the ability to own something that replicated the movement and performance of these 30 stocks. Today, the most widely owned index is the one that follows the S&P 500. The S&P 500 index represents 500 large companies which many consider to be bellwethers of the U.S. economy.

Just like mutual funds investing in all sorts of indexes, there are now ETFs which do the same-yet ETFs have some major design advantages. Let's compare the two:

a) Mutual fund internal costs are often higher than ETFs, thus enabling the ETF to earn a return closer to the index. Lower internal fees mean higher returns.

b) A mutual fund buyer or seller will receive the price as of the close of the market each day. An ETF can be traded throughout the day creating a great advantage if the market is experiencing a powerful move. In times of large market movements, being able to trade in real-time is superior than having to accept the price at the end of the trading session.

c) Unlike a mutual fund, the stock-like characteristics of an ETF allow one to use a limit order or a stop-loss order, be sold short and traded on margin.

d) A mutual fund is required by law to distribute capital gains at year end, and ETF does not of distribute much in the way of capital gains helping keep taxes under control.

ETFs are not perfect, however. They do have some disadvantages relative to mutual funds.

a) ETF's stock-like characteristics lend themselves to a higher degree of trading and short-term speculation leading, in many cases, to underperformance if used unwisely.

b) Like buying and selling stocks, ETFs generate brokerage commissions which can add-up over time and reduce returns.

c) Many new ETFs track arcane and complicated baskets of securities which are untested in the marketplace. These baskets range from commodities to currencies to bonds-adding further to the risk.

d) There are ETFs which magnify the movement of the underlying index by 2 or 3 times making them a dangerous instrument even in experienced hands.

There a many more differences both good and bad between ETFs and their mutual fund counterparts, so their use should be understood before an investing. On balance speaking as an experienced advisor, I can recommend their use in most instances.

Do your homework first however, and remember you must always "know what you own" before committing your first dollar.


at 5:07 PM
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