Exchange Traded Funds

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Exchange Traded Funds, or ETF’s as they are commonly referred to, are quickly becoming the new darlings of Wall Street. The first U.S. ETF was the Standard & Poor’s Depository Receipt, or “Spiders”, which was introduced on the American Stock Exchange in 1993. Since then they have grown in number. ETFs grew from 100 ETF funds at the beginning of 2006 to over 400 funds by the end of that year. Their original design was intended to compete with index funds.

So what exactly are ETFs? An ETF is similar to a mutual fund in that each ETF share gives the investor a tiny piece of the numerous companies that are held in the fund. Like an Index Mutual Fund an ETF is a type of investment company which invests its funds in stocks that mirror some particular market index, such as the S&P 500 or the NASDAQ 100. The ETF fund’s portfolio of public company stocks is packaged into Creation Units, which are sold to large investors (i.e. institutional investors) in the primary market. The institutional investors then split up these Creation Units into smaller units, or shares, which are then sold as ETF shares to smaller investors on the secondary market. All ETFs seek to achieve the same returns as the particular market index it mirrors. For example “Spiders” invest in all of the stocks contained in the S&P 500 Composite Stock Price Index.
The main attraction of ETFs for investors is their very low expense ratios (fees charged by the fund, expressed as a percentage) compared to that of mutual funds. An ETF fund typically charges between .1%-1%, whereas mutual fund fees can range from 1%-3%. Also, ETFs have a much lower turnover ratio (the sale of company-owned stock that is sold within the fund during the year, also expressed as a percentage) as compared to traditional mutual funds. This lower turnover ratio means less capital gains distributions to investors and thus lower taxation. ETF investors generally only realize capital gains when they sell their ETF shares. For this reason ETFs are considered tax efficient investments.

The main advantage of ETFs over mutual funds, besides the low expense and low turnover rates, is that ETFs trade just like stocks. Their stock-like features include the ability to sell short, use stop-loss orders or buy on margin. ETFs also have the capability for options to be written against them. Another important difference is the fact that ETFs are more liquid investments than mutual funds. ETFs trade throughout the day, whereas mutual fund investors can only purchase or sell units at the end of the day.

While ETFs may appear to be an ideal investment there are some disadvantages. Like stocks, ETFs charge a commission every time an investor buys or sells an ETF. Commissions make ETFs somewhat unattractive, due to their high cost. One of the biggest advantages of mutual funds is the ability to buy and sell them without incurring any commissions. ETFs often trade their shares more rapidly to maintain a higher cost basis of their underlying shares and this can result in ETF dividends failing to be treated as qualified dividends. Qualified dividends have a low 15% tax rate.

ETFs can be grouped into four basic categories: Broad-Based ETFs, Fixed Income ETFs, International ETFs and Sector ETFs. Broad-Based ETFs follow specific indexes styles such as growth indexes, value indexes, small-cap, mid-cap and large- cap indexes. Fixed Income ETFs track indexes for corporate and Treasury bonds. International ETFs track indexes for foreign countries as well as international regions (i.e. Asia). Sector ETFs track indexes for specific industries such as health care.

ETFs can minimize market risk by allowing a broad investment opportunity. Imagine having the opportunity to invest in 3,000 companies at once. It would take some disaster to the entire U.S. market to negatively impact your ETF investments. ETFs offer diversification, liquidity and tax efficiency like no other investment. Individuals work hard for their money and oftentimes rely on their financial advisors to provide them with as much upside potential as possible while limiting the downside. ETFs help both Financial Advisors and their clients sleep better at night.