With the popularity of index mutual funds, it was just a matter of time before a spinoff investment appeared. Back in the early 1990s, the first exchange-traded fund (ETF) was created and sold. Since then, ETFs Investment has grown by the billions (though they still pale in comparison to mutual funds held), more often becoming the security of choice around which to build a portfolio. Strong performance and flexibility keep these securities among investors’ favorites—and more new ETFs are being introduced all the time.
What Are ETFs?
ETFs are exactly what they sound like: funds that trade on open exchanges. Just like buying stock, you’ll need to place a brokerage order to buy ETF shares over an exchange. The very first ETF, which tracked the S&P 500 Index, was traded in 1993 on the AMEX. Though at first investors were confused by these new securities, they soon caught on among investors and brokers alike.
Today, ETFs claim more than 500 billion of investing dollars. Sounds huge, but it’s not when compared with the total mutual fund market, which starts counting in the trillions. Given the very real advantages of ETFs, though, they may eventually out-pace mutual funds as the diversified investment of choice. Each ETF tracks a specific index (like the Dow Jones Industrial Average or the Russell 2000, for example), meaning that it holds the same basket of securities as the index. Some ETFs represent stock indexes; others represent bond indexes. There are also more specialized ETFs that allow you to invest in real estate, commodities (like gold), or international securities.
Why Buy an ETF?
Why would anyone buy an ETF matching an index when a mutual fund can beat the index? Managed mutual funds offer hit-or-miss performances. They do sometimes outperform their relevant index, but they also underperform; there’s no guarantee either way. On top of that, managed mutual funds usually charge hefty fees, and that always eats into profits.
ETFs investment is virtually the same as index mutual funds, but with some very important differences, the most important of which is that they trade like stocks on the secondary markets while mutual fund shares have to be bought from and redeemed with mutual fund companies. Other differences include trading choices, tax treatment, fees, and transparency.
ETFs Investment vs Mutual Funds Investment
The first big difference between ETFs and mutual funds is how they are traded. ETFs are bought and sold over exchanges, like stocks, at any time during the trading day. Mutual fund shares can only be bought from or sold to the mutual fund company, and only at that day’s closing price. On top of that, there are no minimum ETF investment purchases, as there are many mutual funds.
But—and it’s a big but—every time you buy or sell shares in an ETF, you will incur brokerage fees, and that can cut deeply into your investing dollars. Another difference is the fees and how they work. Sometimes you’ll fare better with an ETF, and other times you’ll have lower expenses with an index mutual fund. ETFs will often have lower expense ratios because they’re designed to incur minimal operating costs.
That doesn’t mean they will always post lower expenses. While the lowest-expense ETFs charge about 0.07 percent fees, there are plenty that charge much more. In fact, some charge as much as 0.50 percent, which is higher than the average index mutual fund charges. As with mutual funds, though, you need to read through the ETF’s fund information to find out exactly what fees are charged to shareholders. And while many mutual funds come with no load (meaning no sales commission), ETFs must be bought through a broker, and that means a commission of some sort.
Invest Bigger Money in ETFs
Because of the high trading cost, ETF investing makes more sense when you’re making bigger purchases. If you have a $7 trading fee, and you buy $50 worth of ETF shares, you’re losing 14 percent of your investing dollars. If you invest $700 in ETF shares, that $7 takes up only 1 percent of your investment, for a lower effective fee.
Income tax impact is another big difference between ETFs and index funds. Because of the way they’re set up, ETFs don’t have the internal capital gains issues that index funds do. When index mutual funds rebalance their portfolios, investors get tagged with the capital gains resulting from the sale of holdings. ETFs, on the other hand, use a different process to rebalance called “creation/redemption in kind,” which means that you won’t be hit with a tax bill as no security sale has occurred. Bottom line: ETFs create fewer taxable events than mutual funds, and that means you get to keep more of your money. (Of course, whichever type of investment you hold, when you sell your shares for a gain, you will be hit with the capital gains tax.)
Transparency is another area where ETFs hold an advantage over mutual funds. Investors can always see exactly which stocks are being held by their ETF. This is in stark contrast to mutual funds, which are only required to report their holdings twice a year. Why does this matter? Knowing exactly which securities your funds are holding makes it much easier for you to avoid fund (or portfolio) overlap, meaning you won’t be holding the same securities in two different funds (or in a fund and singly in your portfolio).
How To Cover Every Corner of the Market
Like mutual funds, ETFs investment encompasses virtually every type of investment you’d want for your portfolio. From equities to debt instruments, from rapid growth to stable income, you can find what you’re looking for in an ETF.
More adventurous investors can tap into their risk-loving sides with leveraged ETFs. Leveraged ETFs track U.S. market indexes, but with added volatility, as they hold options and futures on the underlying securities rather than the securities themselves. These funds can help aggressive investors tap into short-term market movements.
Equity ETFs cover the stock markets from every conceivable angle. There are broad-based, total U.S. market ETFs, such as those tracking the S&P 500, the Dow Jones Industrial Average, and the Russell 3000. You can also find global (with or without U.S. stocks included) ETFs, such as those tracking the MSCI All Country World Index (ACWI).
More targeted international ETFs track more focused indexes, like the MSCI EAFE (Europe, Australia, Far East) Index or the MSCI Emerging Markets Index. If you want to keep your money in U.S. securities with a narrower focus, you can look into sector ETFs, which track niche portions of the stock market (like utilities or technology). If value investing is your passion, there are ETFs for that, such as those tracking the S&P 500 Value Index (a subset of the whole market index). The same goes for growth investing, where you can get an ETF that tracks, for example, the Russell 3000 Growth Index.
Fixed-income ETFs allow investors to capitalize on the benefits of bonds with the convenience of stocks and the inherent diversification of bond mutual funds. These ETFs are a little different than the equity variety, as they hold portions of bonds that are included in their tracking index (whereas equity ETFs hold whole stocks). Investors get their bond interest as dividends (though it still usually counts as interest for tax purposes).
You can invest in total bond market ETFs, which hold corporate and government bonds of varying maturities. You can also invest in more specialized bond ETFs, such as those that focus on specific maturities (like only tracking bonds with maturities of less than three years), or inflation-indexed bonds. Finally, there are highly specialized, alternative-investment ETFs available.
These allow investors to dabble in commodities and currencies, or to take a riskier investing approach. Commodities ETFs will hold either the goods themselves (like gold) or futures on the goods. They may track single commodities, a basket of several commodities, or shares in companies that produce commodities. Currency ETFs track money movement, holding either foreign currencies themselves or future contracts.
You’ll find single currency ETFs (such as those focusing on the Japanese yen or the euro) as well as currency-basket ETFs (which hold several different currencies). Inverse ETFs allow investors to bet against the market—these funds move opposite to a major market index, basically by short selling the index components. For example, an inverse S&P 500 ETF would go up 1 percent for every 1 percent the index itself went down, and of course, the ETF would drop every time the real index increased.
Spiders, Diamonds, Vipers, iShares, and Cubes
SPDRs, the very first U.S. ETFs, were created by State Street Global Advisors. These funds tracked the S&P 500 and gained the nickname spiders, which comes from SPDR (Standard & Poor’s Depositary Receipts). SPDRs trade on the NYSE, with SPY for their ticker symbol. Along with the broad index ETF, you’ll also find SPDRs that track specific market sectors, aptly named Select Sector SPDRs.
When you buy a share of Diamonds (NYSE: DIA), you are buying a fraction of each of the stocks in the Dow Jones Industrial Average. Like SPDRs, Diamonds are exchange-traded funds bought and sold on the NYSE, and sponsored by State Street Global Advisors. VIPERs are ETFs issued by Vanguard, a leading mutual fund provider.
VIPERs (which are formally known as Vanguard Index Participation Equity Receipts) cover the U.S. stock and bond markets, as well as some international equity markets. Barclays Global Investors (now BlackRock) launched their own version of ETFs under the iShares name. BlackRock is currently the world’s largest ETF source. Investing in the iShares family gives investors immense diversification opportunities, as these ETFs cover everything from currencies to emerging markets to fixed-income securities. Cubes company, which trades under the QQQ symbol, tracks the very popular NASDAQ-100 Index. They are brought to you by PowerShares, a relatively new player on the ETF block. This company offers investors the opportunity to invest in more than straight indexes. Rather, they focus on “dynamic indexing,” which allows them to hone in on the best-performing securities within an index.
Fitting ETFs Into Your Portfolio
ETFs can be used to enhance diversification in your portfolio. With just a few strategically selected ETFs, you can create a well-diversified set of core holdings, covering virtually every corner of the market. For far less than the cost of holding individual stocks, your ETF can give you exposure to all the major equity classes: every size of market capitalization and every market sector.
You can round out your holdings with one or two fixed-income ETFs. These offer you the benefit of steady income, just like you’d get by holding individual bonds or bond funds, with the flexibility of stock trading; bond ETFs trade over exchanges, whereas bonds, can only be bought through brokers or TreasuryDirect. For more portfolio protection, you can branch out into foreign ETFs. These offer you a hedge against problems in the U.S. markets, as other countries may be doing well when the U.S. markets are down.
Global ETFs let you stick your toe in international securities, so you don’t have to figure out which securities—or which countries—to invest in. Holding ETFs does not mean you can’t also hold mutual funds. Managed mutual funds are designed to outperform the markets, while ETFs aim mainly to match the markets. A combination of core ETFs and some more aggressive mutual funds can keep your portfolio profitable without risking too much stability.
Choosing the Right ETFs
When it comes to figuring out which ETFs make sense for your portfolio, the process is very similar to mutual fund selection. The first thing you need to do is revisit your financial plan. Your immediate and long-term goals, your current holdings, and your feelings about risk will all inform your ETF choices. You’ll also want to consider the expense situation. If you choose a broad-based ETF that holds basically the same securities as an index mutual fund, carefully measure which one will cost you the least to own, remembering to take trading costs into account.
There’s no reason to buy the ETF if a no-load mutual fund will offer you the same returns at a lower cost. You’ll also want to check the current trading prices; while mutual funds are bought and sold at their net asset value, ETFs often trade at premiums or discounts to the NAV, based on the day’s market activity. Also, consider the different fees charged by different ETF families. Competition among ETFs is increasing as more players come into the market, and one way to draw new business is to lower fees. Compare like ETFs to see which offers the best expense ratio, especially if you plan to add only one of these securities to your portfolio.
Asset Allocation ETFs
Asset allocation ETFs can take all the guesswork out of investing. Just like their mutual fund cousins, these relatively new ETFs hold more than one class of securities, such as stocks and bonds. That allows investors to hold a single ETF for a fully diversified portfolio.
As you’re looking into different ETFs, you’ll also want to make sure that you’re putting your investment dollars into good hands; not all ETF sponsors are alike. Make sure the ETF you’re considering holds at least $10 million in assets, as smaller offerings may not be as liquid (meaning you may have trouble selling when you want to). Also, look into the trading volume of the fund you’re interested in, as that will also tell you how easy it will be to sell when you’re ready. Popular ETFs see volume in the millions every day (meaning more than 1 million shares exchange hands daily), while others may see virtually no trading activity at all.
How to Buy and Sell ETFs
Trading ETFs is just like trading stocks—literally. You place a buy or sell order with your broker, and he fills the order for you, adding the securities to your ac- count when the transaction is closed. Whenever the market is open, you can make a trade. And just like stock orders, you can add conditions to your ETF trading orders. For example, you can place a limit order for an ETF, just like you would for a stock. In fact, everything you can do to order a stock trade, you can do to order an ETF trade, from time-sensitive to price-driven orders.
Many investors take an active approach to ETF trading, which is much less common with mutual fund holders. Though the ETFs themselves take a passive investment approach, simply tracking an existing index, traders can buy and sell ETF shares in the same way they would with individual stocks. People who do this are typically trying to beat an index, but their profits can be eaten up in trading commissions—and their strategy may turn out to be less profitable than simply following the index.
Tracking Your ETFs
Keeping track of your ETF holdings is as easy as—you guessed it – keeping track of stocks. Every financial reporting service, from the Wall Street Journal to Reuters to the ETF sponsor, maintains current pricing and yield (for income ETFs) information for the ETFs on the market. To track your ETFs, you’ll need to know their trading symbols. Then all you have to do is look at a current price table, whether in the newspaper or online, to find out everything you need to know. Most ETF price tables contain data like closing price, the dollar and percent change from the previous trading day’s closing price, and trading volume. Some also include the year-to-date price change, the day’s high and low prices, and the annual high and low.
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