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Funds
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Mutual Funds
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Index Funds
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Closed-End Funds (CEFs)
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Exchange Traded Funds
(ETFs)
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Hedge Funds
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Separately Managed
Accounts(SMAs)
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Exchange Traded Funds (ETFs)
Exchange Traded Funds
have the potential of becoming the most innovative financial products of the
21st century!
What is an Exchange
Traded Fund? An exchange traded
fund is an index type fund, whose performance is tied to a fixed basket of
stocks, bonds or other securities. The performance of the exchange traded
fund closely approximates the performance of the underlying securities, and
trades similar to common stock on the exchanges. The fund attempts to match
certain indexes, industries, countries, or strategies involving any tradable
asset class.
Who are the players?
Currently, the big institutions
participating in this market are: Barclays Global Investors, State Street
Global Advisors and Vanguard. Over the next few years, however, expect to
see all the asset management companies roll out products.
What are investors
buying? Investors are
participating in ETFs that have some very unusual and creative names; expect
more catchy names as the marketing professionals promote these products.
Below are some of the current offerings:
·
iShares
– Offered by Barclays Global Investors to mirror common indexes
·
Street Tracks
– Offered by State Street Global Advisors and tracks various indexes
·
Spiders
–Run by State Street and tracks the S&P 500
·
Diamonds
– Tracks the Dow Jones Industrial Averages
·
Vipers
– Vanguard Index Participation Equity Receipts
·
Qubes
– Tracks the NASDAQ-100 Index
·
Holdrs
– Marketed by Merrill Lynch and tracks focused industry groups
·
Fitrs
– Tracks various treasury securities
Why is the market
expanding so rapidly? On average,
investors are anticipating lower returns going forward. As a result, cost
structures become more important, as investors try to reduce expenses in an
effort to improve their returns. Additionally, as investors are aging, their
appetite is changing; their focus is switching to broad trends, rather then
individual companies. They are looking for higher returns and lower risks.
ETFs fill these needs. If purchased correctly, exchange traded funds can be
low cost alternatives to mutual funds. A 1% plus annual savings is common.
ETFs, however, are purchased through brokerage firms, so commissions and
account management fees are involved. Comparative shopping is needed; much
of the expense savings can be eaten up by commissions. Of course, if the
commission is a one time charge, and you hold the fund for a long time, the
effect of the commission diminishes. Nonetheless, as account balances grow
and time passes, the expense differential can make a very significant
difference in the value of one’s account.
What are the Pros and
Cons for Exchange Traded Funds?
Pros:
- Low expenses
ratios attributed to low trade
volume, research, and operational expenses.
- Reduce individual
specific company risks.
- Flexibility
is one of the main growth drivers to these securities. ETFs can be
purchased and sold throughout the day, similar to common stock. This is in
contrast to mutual funds, which are only traded at the end of each day.
- Multiple trading
benefits - ETFs are considered
marginable securities and can also be shorted. Options may also be
available. The use of stop and limit trading orders are also at one’s
disposal.
- Cash flow
potential - Dividends, less
expenses, are passed to the investors. Mutual funds don’t have the same
advantage; with mutual funds, dividends are needed to pay the firms’
operating costs.
- Tax efficient
structures - ETFs by their very
nature have low turnover, resulting in minimal pass-through capital gains
or losses. The gains or losses usually occur due to changes in the
composition of the indexes they track. Financial institutions have an
added advantage over individual investors, in that they can receive
in-kind redemptions to further minimize their taxes. All investors,
however, are still subject to capital gains or losses when shares are
sold.
Cons:
- Average
performance - ETFs are passive
funds, only designed to replicate a benchmark index or basket of
securities; they are not intended to outperform the averages. Mutual
funds, however, are actively managed funds that are designed to try to
beat the averages.
- Another middleman
- ETFs can never duplicate the performance of the underlying shares/index,
because they still have expenses.
- No DRIP’s
- ETFs don’t have automatic dividend reinvestment plans; one has to pay
commissions to reinvest dividends.
- Not exact
- ETFs can be mispriced, allowing traders to profit from arbitrage
opportunities, at the expense of the individual investors. The value of
the underlying shares can be different than the price of the ETF.
- Hidden cost
- ETFs are traded on the exchanges, resulting in a bid–ask spread which
always costs the investor. Mutual funds, however, are purchased and
redeemed using the NAV (net asset value) of the fund at the end of each
day, which is a much fairer process.
- No accountability
- ETFs are liked by the financial advisors. They are commissionable
products with no one responsible for their performance. With ETFs or any
index fund, investors are entrusting their money to a legal structure that
is faceless. Billions of dollars are being invested where there is little
accountability for results.
How Do ETFs Work? Structurally, ETFs are open-ended investment companies or unit
investment trusts, where the sponsor borrows a basket of securities, usually
from large institutional investors (authorized participants), to form
creation units. Deposits and redemptions affecting creation units are
accomplished with “in-kind” exchanges; cash is normally not used. The
creation units are placed in a trust; the trust issues fractional shares of
the ETF to the authorized participants. These shares are then sold to the
public, allowing other investors to purchase shares. The trust is
responsible for distributing dividends, and provides administration
oversight.
If additional ETF shares
are needed to meet market demand, additional securities replicating the
creation unit can be deposited in the trust, and additional ETF shares can
be sold.
A nice feature of ETFs
is that trading shares has no effect on the operations of the funds. Regular
investors usually trade shares with existing investors. Trading takes place
on the exchanges, in the secondary markets.
Large investors, usually
financial institutions, who own enough shares, can redeem their shares by
reforming the creation unit and exchanging their shares for the actual
underlying securities. This eliminates operational liquidity issues and
prevents the forced selling of large blocks of securities. Additionally,
in-kind exchanges defer realizing taxable capital gains or losses until the
original stock is sold. Mutual funds are more complex, because one purchases
and redeems shares through the fund, requiring management to constantly
balance the flow of funds.
Where did they
originate, where are they going and are they worth considering?
ETFs were introduced to the public in 1993 by the American Stock Exchange
(“AMEX”) and have since become an investment of choice for many investors.
This is turning out to be a revolutionary innovation by AMEX. ETFs are now
very popular and have very sophisticated uses. In the future, expect to see
more exotic funds, indexed to virtually any conceivable strategy. Managed
ETFs are also being discussed.
How do you research
specific ETFs? Below are a few of
the companies that track ETFs:
- Lipper Inc -
available at
www.lipperweb.com.
- Morningstar -
available at
www.morningstar.com.
- Standard & Poor’s
Inc.
- Yahoo Finance’s
Exchange-Traded Funds Center.
ETFs are very good
investments; however, as with all investments, you need to do your homework
and be cautious.
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