Tuesday, June 21, 2011

ETF: Exchange Traded Fund or Every Trader’s Fantasy

Pathways Advisory Group, Inc.
Jeff Karst, Associate Planner

Newspapers, magazines, and TV are overflowing with advertisements for ETFs (exchange-traded funds). You might think that ETFs are new. Not so. The first ETF started in 1993 but the industry has grown a lot the last few years.
What is an ETF?
An ETF is a basket of securities similar to a mutual fund with many distinct differences. A mutual fund begins by collecting money from investors to buy securities. An ETF starts at a large company that already owns the securities. The securities are packaged together into an ETF. Some say that an ETF is like a stock since it trades like one but this is not true. The ETF company owns the securities and you own the ETF. This makes ETFs more of a derivative instrument. The value of the ETF is derived from the underlying securities.
Mutual funds must be purchased directly from the mutual fund company. Once the ETFs are provided to the market, they are sold on an exchange similar to a stock. They may be purchased or sold throughout the day at the market price. Mutual funds can only be purchased or sold at the end of the day once the NAV (Net Asset Value) is determined. Since the ETF price is determined by supply and demand, you rarely purchase at the NAV. This is an added risk with ETFs. Just ask the unlucky investors who sold ETF shares during the Flash Crash.
Pros for ETFs
ETFs are not actively managed and therefore have very low expense ratios (similar to an index mutual fund). Low expense ratios leave more return for the actual investor…. you. ETFs are tax efficient. The ETF never has to sell shares to accommodate liquidation like a mutual fund. There will be little if any capital gain distributions from an ETF.
Active traders love ETFs. ETF orders are exactly the same as an order for a stock. You can use stop and limit orders depending on what price you want to buy or sell at. ETFs can even be sold short (betting that the price will fall). There are even options available for ETFs. (So it’s a derivative of a derivative?....Sounds complicated.) ETFs facilitate the gambling addiction of the active trader while allowing some risk diversification.
Cons for ETFs
ETFs trade like a stock which means every time you buy and sell you pay a commission. There are some low cost brokers out there so this could be minimal. You could purchase at a premium to the NAV (paying more than its worth).
Only whole shares of ETFs can be purchased. Mutual funds allow you to purchase dollar amounts and receive fractional shares. Both ETFs and mutual funds pay dividends. With a mutual fund you can have your dividends reinvested. You simply buy more fractional shares of the mutual fund. When an ETF pays a dividend, it must pay to cash. There is no reinvestment of dividends. You would be required to place another buy order.
Some mutual fund companies have automatic investing programs. The mutual fund company can take $50 from your checking account after each payday and automatically invest for you. This is not available for ETFs. You are required to place each trade.
ETFs are very popular right now because they provide low cost diversification (with the ability to buy and sell throughout the day) and inexpensive access to sector investing. For the long-term investor, we feel mutual funds remain a better alternative.

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