Exchange traded funds are index funds which have advantages over open-end index mutual funds. ETFs trade all day long on the stock exchanges, may be purchased through any broker, have lower fund expenses than mutual funds, and have less likelihood of generating unwanted taxable gains than mutual funds. (See The ABCs of ETFs – Exchange Traded Funds).  

There are a number of reasons, which we’ll discuss, for investing in index funds (ETFs or mutual funds) but let’s start with the fact that the S&P 500 index beats 80% of all actively managed funds. (And, an index fund has lower expenses than an actively managed fund, further enhancing its net return.) If you can invest in an index fund and be in the top 20 percentile of fund returns, that’s a pretty good place to start. 

 

You can construct a well-diversified portfolio entirely out of ETFs.  There are ETFs for almost every type of investment you can imagine.   ETFs enable you to diversify into assets which you may not otherwise feel comfortable owing because of expertise, risk and/or liquidity issues. ETFs are well-suited for investing in exotic areas such as currencies and commodities. Of course, they’re great for sectors such as small cap or international stocks. 

One of the most attractive features of ETFs is their ability to provide you with greater liquidity than if you were to directly own their underlying investments. Take municipal bonds, for example. Most Muni issues trade infrequently and the transaction costs for the individual investor are substantial. Minimum investment size can be another problem. Munis typically have a $1,000 denomination and trade in large blocks. ETFs are the answer to all these issues.  You can buy as little as one share of an ETF (generally less than $100) during market hours and at the same cost as for a stock.   

 

You can hedge an investment and/or lock in gains using ETFs.  Unlike open-end mutual funds, ETFs can be bought on margin and shorted. Investing on margin can magnify your returns and your losses. The ability to short enables you to make money when something goes down in value. Think shorting the dollar or home building stocks. However, to paraphrase TV commercials, these strategies should only be employed by a professional driver on a closed course. It’s also important to note that you don’t have to short an ETF if you think an asset is going to decline in value. You can probably find an ETF which is structured to generate an inverse return to that asset. ProFunds Group has a number of ETFs designed to perform this way. So, for example, if you think the Chinese stock market will decline, you can purchase a ProFund which should increase in value if you’re right. 

All ETFs, even those which track the same index, are not the same. One S&P 500 ETF may weight its stock holdings by market cap, another may weight them all equally. This will result in different returns. Two ETFs which track the technology sector may hold different stocks and/or in different weightings. Since most indexes are not strictly defined, think technology versus S&P 500, there will be a variety of different investment strategies employed. Different strategies to mimic an index are not good or bad, but they may have different risk levels and will produce different returns. Some ETFs  also use leverage to enhance their returns or structure there holdings to magnify any gains (thus, also losses) of an index. You need to know what you’re investing in. To understand how a specific ETF works, visit its website and read its prospectus. Want to learn more about ETFs or take a look at some of the most popular? Go to I shares, Power Shares, or HOLDRs.

 

Within five years most investors will have at least one ETF in their portfolio. Also, within five years, there will be more money invested in ETFs than in open end index mutual funds. The advantages of ETFs – liquidity, transparency and lower expenses, to name a few – will force changes in open end mutual funds.  Happily, the investor will be the winner in the competition between these two investment vehicles.

Every investor should consider Exchange Traded Funds (ETFs).   The younger brother of open-end index mutual funds is growing up fast and showing greater versatility.

 

ETFs are open-end index mutual funds that trade like stocks (and closed-end mutual funds). 

 

There are three legal structures of ETFs: Open-end mutual fund (the difference between the ETF structure and a open-end mutual fund is the ETF is exchange traded, whereas the traditional mutual fund is purchased and redeemed by the fund itself), Unit investment trust and Grantor trust.   The open-end mutual fund structure has a diversification requirement, mandated by the Investment Company Act of 1940, which limit how it mimics some smaller or specialized indices and could result in a tracking error. The other principal difference for the investor is that other than the open-end mutual fund, dividends must be paid out in cash to investors (of course, you could reinvest them if you desired), rather than reinvested by the ETF. These structural differences aren’t significant for most investors. The more important question is whether it’s the right ETF for you in terms of what index it’s designed to follow. The index and dividend payout requirement are disclosed in its prospectus and most ETFs also have websites where you can find this information.

 

Tracking error is the difference between the return on the index the EFT is designed to follow and the actual return on the index. An EFT which holds all 500 stocks in the S&P 500, in the same weighting as the S&P 500, should have exactly the same return as that index, less fund expenses. That’s an easy one. ETFs that are created to track, say, the biotech stock index will have different interpretations of that index. A biotech ETF could weight all stocks equally, weight by market cap, hold big cap or small cap bio stocks, and so on. As a result, the ETFs performance will vary with the success of its strategy. A good illustration of this is in Biotech ETFs: It Pays to Shop Around, in the October 15^th BusinessWeek. The five funds BusineesWeek highlights had year-to-date return ranging from -3.7% to 27.3%.

 

ETFs are required to disclose their holdings every day, unlike mutual funds which only have to disclose once a quarter. However, this should not be a big deal because we’re dealing with index funds and the components of indexes should not change very often.

 

There are two aspects of ETF liquidity for investors to consider: the ETF and its index’s securities. Since ETFs trade like stocks, they can be traded all day long. Open-end mutual funds can be purchased or redeemed only once daily, after the market closes. You have to put your order in prior to 4PM (while the stock market is still open) or wait until the next day. The liquidity of the EFT – the frequency with which it trades and the depth of the market – is similar to a stock and parallels the size of the EFT. But ETFs also have a very unique feature, they can be expanded or contracted depending upon demand, see Share Creation/Redemption, which provides them with even greater liquidity. And, ETFs can be more liquid than the individual shares they hold, thus, providing investors with greater liquidity. This is especially true for an ETF that holds small cap stocks, which are thinly traded, or bonds other than US Treasuries, which trade infrequently.

 

Authorized Participants, think big banks who act as market makers or specialists on an exchange, trade market baskets of the underlying index’s securities to the EFT in exchange for new ETF shares, when the demand for ETF shares increases. The Authorized Participants then sell these newly created ETF shares on the open market. The process is reversed if there are more sellers than buyers of the ETF.  The purpose of this feature is to keep the ETF’s market price as close to its net asset value as possible. (The risk exists that the Authorized Participants would not, or would not be able to, perform this function during a market crisis. The result of this could be an ETF which trades away from its net asset value.)

The price at which the ETF trades is based upon supply and demand. Unlike the share of an open-end mutual fund which is purchased or redeemed at its net asset value (NAV), the price of an ETF share may trade above or below its NAV. By way of comparison, closed-end mutual funds often trade away from their NAV for extended periods of time. Unfortunately, many closed-end mutual funds trade significantly below their NAVs. The Authorized Participants provide vital role, through share creation and redemption, in keeping the price of the ETF close to its NAV.

The structure of ETFs gives the investor a tax advantage over mutual funds. Open-end mutual funds, even index funds, must sell shares of the stock they own to raise cash when redemptions exceed purchases. These sales can result in taxable gains and losses which are passed along to the investor. Thus, you could have a taxable gain on the fund you own, even though you didn’t sell it. The share creation/redemption process for ETFs shifts this liability to the Authorized Participant. If the Authorized Participant trades ETF shares to the EFT, it is responsible for the taxes on any gains if it sells the securities it received from the ETF. Of course, the investor is liable for any taxes when he or she sells an ETF or mutual fund. 

ETFs have lower fund expenses than index mutual funds, although the difference is usually only a few basis points. (Don’t be misled by ETF advertisements which compare their expenses to actively managed open-end mutual funds.) Theoretically, the expenses for an ETF or mutual fund structured to track the same index, assuming they’re roughly the same size fund, should be the same. 

 

Since ETFs are traded like stocks, the commission charged to buy or sell an ETF is similar to the commission on a stock trade. Index funds are no-load, and are commission free, although some charge a back-end fee if you don’t hold it for a certain period of time. The second cost to consider is the bid/ask spread. Even stock and ETF has one, although in most cases they’re very small, i.e., a few cents, unless the ETF is very illiquid. Transaction costs – none vs. some – favor no-load mutual funds over ETFs but the cost differential is slight

 

What are the uses and advantages of ETFs? Come back next week and I’ll tell you.

Let’s dispel the notion once and for all that index funds are only for passive investors. Sure, the original index funds tracked the S&P and were meant for investors who either believed you couldn’t beat the market or didn’t want to try. Since their beginning, index funds have expanded their breath. You can find a fund which tracks any of the major indices and most industry sectors, such as health care and technology. The first cousin of index funds, Exchange Traded Funds (ETFs), do the same thing – they track indices. Between index funds and ETFs you can mirror any major index, small index, industry sector, industry sub-sector (i.e., biotech or software), global region or individual country. You can also try to outguess the indices if you want. For example, you can buy a S&P index fund which weights all 500 stocks equally or one which weights them by market cap, and so on. (Note to investors: make sure you know what you’re buying.) Thus far, we’ve only focused on equity funds but index and exchange traded funds also are available for fixed income securities. These funds are particularly suited for fixed income investments (Treasury, corporate or muni) because they can buy and sell bonds at much lower spreads than individual investors.

 

The proliferation of index and exchange traded funds means you can construct an entire portfolio of these funds to meet almost any investment strategy and risk level. A combination of a S&P fund, mid-cap and small cap domestic equity funds, foreign funds and fixed income funds of varying maturities, and a real estate fund would fit many investors objectives for a diversified portfolio with good growth potential and reasonable risk.

 

A mix of funds with individual securities or using a fund to fill a gap in your portfolio is an equally good idea. For the investor who wants to participate in, for example, biotech or emerging markets, a fund will enable her to achieve diversification in that sector (and the riskier the investment, the more important diversification becomes) with only a small investment.

 

Index funds can be bought and sold once a day; some ETFs as frequently as every hour. The larger funds are liquid investments and, in many cases, more liquid than their underlying securities (bonds and small cap stocks, for example). Transaction costs are modest, perhaps nothing for a no load fund (subject to certain holding period requirements) and typical stock commissions for an ETF.

 

So what’s the downside? There’s a body of academic literature and models which “prove”’ that a small group of fund mangers can outperform the market, think Peter Lynch and Bill Miller. If you believe this, and I do, or you just want to hedge your bet (I shudder as I write those words because investing is not a bet, it’s hard work and serious business), you can mix some actively managed funds in with your index funds and ETFs. The other issue you have to consider is that index funds/ETFs can take different investment strategies to for the same index. I gave the example above of two S&P 500 funds that are constructed differently. They will perform differently as a result. Structure and performance differences are even more pronounced as you invest in riskier/smaller indices. Taking biotech, for instance, one fund may broadly diversify, another may invest in the ten largest biotech companies, and a third may take a different investment approach. As a result, their performance will widely differ. So, again, make sure you understand your fund’s approach.  You can’t tell a book or a fund by its name.  Index funds and ETFs have a place in your portfolio; they’re no longer just for passive investors. 

 

There was an excellent article discussing the pros and cons of investing in ETFs in the July 3^rd Wall Street Journal: As ETFs Seek Niches, Risks Rise (unfortunately, The Wall Street Journal doesn’t allow us to link to their articles, perhaps that will change after Rupert Murdoch buys Dow Jones.) There’s over $500 billion invested in ETFs and, I believe, they will either replace open-end index mutual funds or force those funds to lower their expenses. A win for investors. ETFs generally have lower on-going expenses then index mutual funds. You’re charged a commission to buy or sell them, as for a stock, but the commission may be less then the fee charged by your broker, or fund, for buying a mutual fund (consider the share class you’re buying). ETFs are priced, and traded hourly, not at the end of the day as with open-end mutual funds.

 

ETFs are excellent tracking vehicles for many different kinds of investments. Want to invest overseas? In commodities? Buy an ETF. (Not to get carried away, there are index funds that track most of the indices that do ETFs.)

 

So what’s not to like about ETFs? Going back to The Wall Street Journal article, Lipper, which tracks fund performance, reported that a disproportionate number of ETFs showed up on its losers (poor performing) list. For some ETFs it is simply a case of tracking a narrow and volatile index, nanotechnology, for example. The lesson here is that investors need to consider the riskiness of any investment they’re making. An ETF doesn’t diminish the risk of a cutting-edge technology, volatile commodity, or stock market of an emerging country. What a good ETF will do is reflect the performance of whatever index its is designed to track.

 

Like most new products, and ETFs are a new product, there will be some product-specific risks as well. Some ETFs won’t track their underlying index due to design error or too narrow a portfolio. Costs won’t automatically be less, turnover and taxes will be issues for some ETFs. To mitigate these risks stick with ETFs issued by well-known institutions.  

 

Vanguard, the godfather of index funds, has joined the ETF party and is coming out with more. (See When is a Door Not a Door for more information on ETFs and what John Bogle, the founder of Vanguard, thinks of them.) Vanguard’s action is perhaps the best evidence to date of the rise of ETFs.

 

The moral to the story is to consider ETFs whenever you’re considering an index fund or want a low cost and liquid way to obtain exposure to a particular type of investment. Just remember that an ETF doesn’t reduce the risk of the investment class.

When it’s an Exchange Traded Fund (ETF), according to John Bogle.   Mr. Bogle is the founder of the Vanguard funds and a champion of low-fee and index funds. He’s one of those people who’ve forgotten more about mutual funds then I’ll ever know.

 

An ETF is supposed to be similar to an index fund. ETFs and index funds are market baskets of securities designed to track the performance of a market index, such as the S&P 500. (Proponents argue that ETFs can have lower costs, greater liquidity, and be more tax efficient then index funds.) 

 

In Mr. Bogle’s just-published book The Little Book of Common Sense Investing he argues that ETFs have been hijacked by day traders and that many ETFs will not track the indexes they’re designed to mimic and will not meet investors expectations. You can find a summary of his arguments in the April 30 BusinessWeek article What’s Wrong With ETFs?  (Yes, I know it’s April 25^th, but publishers seem to be able to foretell the future. As an investor, I wish I could do this.) He’s not alone in expressing concern about ETFs. Two articles which discuss the potential pitfalls of ETFs are Beware the Flaws in Trading ETFs in The Street and Too Many ETFs in Forbes, both published March 20^th.

 

Are all ETFs bad? Of course not. Are they a viable substitute for index funds? Yes, the well-structured liquid ETFs are. Even Vanguard evidently does not entirely agree with its founder. It offers over 30 ETFs. Hopefully, Mr. Bogle would find Vanguard’s ETFs to be in the good category.

 

ETFs are like any other investment. You can’t just go by the name, you’ve got to open the door, dig around and reach your own conclusion if it is what it says it is and if it’s right for you.