Posted: 5/17/2008 1:19:50 PM EDT
|
For those who are curious about investing in ETFs: ETFs What is an ETF? ETFs are a mutual fund/stock hybrid. ETFs are baskets of individual securities packaged together by a firm (like mutual funds) and traded on an exchange. Like stocks, they can be traded throughout the day as opposed to open ended mutual funds which are traded at the end of each business day. Also like stocks, ETFs can be sold short and bought on margin. Basically, anything you can do with a stock, you can also do with an ETF. ETFs typically track a specific index (this can be sector specific, country specific, or other index), which means they are passively managed (a manager isn't actively choosing which stocks to buy and sell). The passive management characteristic of ETFs results in lower expenses than most similar index mutual funds. Most ETFs cannot be bought from or sold back to the fund company like regular mutual funds (except for Merrill Lynch's HOLDRs). To create an ETF, investing institutions (typically those that control a vast number of shares of stock) put together a basket of stocks (using their existing holdings) to represent the appropriate index they want to model (the S&P 500 for example). They deposit the shares with a holder and receive a number of “units” in return. A “unit” is a large block (often 50,000 shares) of the new ETF. These new units are then split up by the institution into the individual shares that are traded on the market. More units, and therefore more market shares, can be made if the investment institution deposit more shares with the holder (to exchange for more units of the ETF). Conversely, the number of outstanding ETF shares can decrease if one of the institution deposits the ETF units for the underlying shares of stocks that make up the basket. Because of this process, aside from institutions and the very wealthy, most people have to go through a broker to buy and sell shares of an ETF. Pricing Unlike mutual funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, the market price of an ETF is determined by the same principles of that of a share of stock. Because of this pricing technique, ETFs may trade at prices above or below the value of their underlying portfolios. Advantages/Disadvantages of ETFs In this section, we compare the advantages and disadvantages of ETFs as compared to their mutual fund cousins. Advantages Expenses The annual expenses of ETFs are significantly lower than most mutual funds, as much as 50% or more in some cases. For example, SPDRs (SPY) charges just 0.08% as compared to an index fund with expenses of 0.2% and higher. If you are considering a purchase into an index mutual fund, explore your ETF options first as the ETF's expense ratio may be cheaper. Flexibility Because ETFs trade throughout the day, you have control over the timing of your transactions. Mutual fund transactions take place at the end of the day at the end of day NAV no matter what time of day you place your order. Tax efficiency Due to their design, ETFs are typically more tax friendly than mutual funds (tax managed funds excluded). With mutual funds, investor redemptions can potentially force fund managers to sell stocks in order to meet the cash requirements to satisfy those redemptions. This can result in capital gains distributions being paid to shareholders, which are taxable in non retirement accounts. In contrast, ETF trades typically take place between shareholders, thus shielding the ETF institution from any need to sell underlying stocks to meet redemptions. Additionally, large redemptions (usually made by large investors) are paid in-kind, again protecting shareholders from tax consequences. One tax characteristic of ETFs to keep in mind, however, is that ETFs may make capital-gains distributions when adjustments of their underlying index are necessary (addition and subtraction of stocks to the index). Disadvantages Trading costs Like stock transactions, you must pay a commission to buy an ETF. Because no load mutual funds can be bought directly from the fund company, or as a transaction free trade from a brokerage, the expense advantage of ETFs may only pay off after holding an ETF for a significant period of time. For example, assuming you pay a commission of $8 per trade, a single lump-sum investment of $10,000 in the iShares S&P 500 Index ETF would need to be held for nearly two years to beat Vanguard 500 Index's (VFINX) costs (assuming the Vanguard fund purchase was without a transaction fee). If you plan on making a single, lump-sum investment, then it may pay to choose an ETF. However, a dollar cost averaging investment strategy will most likely result in higher expenses overall as compared to mutual funds. |