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Exchange Traded Funds (ETFs)
In 1993, the Securities and Exchange Commission (SEC) authorized a new class of investments generically labeled as Exchange Traded Products (ETPs). Since the majority of ETPs are actually Exchange Traded Funds (ETF), let's use that acronym to describe this investment category. ETFs were initially only allowed as index-based funds. The SEC authorized the selling of actively managed ETFs in 2008, and the number of ETFs has increased rapidly since then.
The simplified definition of most ETFs is a mutual fund that can be traded like a stock on the open market during market hours. The difference between ETFs and mutual funds is that mutual funds are traded on an end-of-day pricing basis. This means all buys and sells are transacted at one price, which is determined by the last price every stock in a particular fund traded for that day. ETFs trade continuously during market hours. Based on liquidity and supply and demand, the range of prices for an ETF can vary greatly during the day.
Advantages of owning ETFs
No minimum investment. Since ETFs trade like stocks and are purchased in a brokerage account, as little as one share may be bought. Many mutual funds have minimum investments of hundreds, if not thousands of dollars.
Market-hours trading is one advantage ETFs have over mutual funds, even though that ability works both ways. With ETFs, an investor can take advantage of rapid changes in the market, perhaps selling before a big drop in prices later in the day, or catching a dip after a false rumor roils the markets at the beginning of the day.
Instant diversification similar to mutual funds. Many ETFs are passively traded funds that seek to replicate the performance of the major indices such as the S&P-500 or the Russell 2000. This allows an investor to own a large basket of stocks or bonds for a relatively low cost compared to owning small amounts of each individual stock or bond in an index.
Some ETFs may also be sold short. There are also a growing number of inverse ETFs that are the virtual equivalent of selling short. This can be an advantage if an investor has a long position in an index ETF or mutual fund such as the S&P-500 index, but believes the market will go down in the near term. She doesn't want to sell her index fund and incur a potentially large capital gains tax, so she hedges her position by either shorting an ETF that is shortable, or buying an inverse ETF, which allows her to potentially profit from a downturn while retaining her long position.
Options are available on many ETFs. Another hedging strategy would be to sell covered calls on an ETF index position or buy puts outright in anticipation of a declining market. None of these strategies is available with mutual fund investing.
Disadvantages to owning ETFs
Investors may be tempted to become market timers day traders with money intended for long-term financial goals. Frequent trading increases price and volatility risk, as well as cost risk, since ETF trades incur commissions on each purchase or sale, and markets can fluctuate widely during the trading day. ETFs can also be short-sold, which is a much riskier trade due to the fact any given stock can rise in price to infinity, while the lowest a stock can go is to $0.00. There is a known maximum potential profit with short selling, tempered with the possibility of infinite losses.
Commissions are a factor when purchasing ETFs. Most of the big name brokers such as Charles Schwab, Etrade, and Fidelity charge less than $10 to buy an ETF. Most brokers charge the same for ETFs as they charge for stocks.
Compared to paying anywhere from $5 to $20 for an ETF, a no-load mutual fund cost of $0 is a no-brainer, especially for a small investment of say $1,000, where a round trip commission to buy and sell an ETF will amount to a 0.10% to 0.40% haircut on the total return of the investment.
Conclusion
Purchased for the right reasons and traded with restraint and discipline, ETFs can be an integral part of an investor's portfolio, as long as the investor is aware of the pros and cons.
ETFs are unique investment vehicles and differ from stocks and mutual funds in subtle but important ways. Anyone considering an investment in ETFs is well advised to do their due diligence
and know exactly what ETFs can and cannot do to enhance their portfolios.
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