Exhange Traded Funds 101

03/31/2006 12:00 am EST


Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

For those unfamiliar with ETFs, we begin our special report with an educational overview from Bernie Schaeffer, who considers ETFs the "wave of the future." Here he reviews their benefits, from flexibility, diversification, and tax and cost advantages.

"ETFs are investments that track a particular index, a broad sector, or a group of international stocks through a basket of securities. Although they are constructed like mutual funds, ETFs trade like individual securities on stock exchanges. This gives investors the best of both worlds, as they combine the conservative diversity of a mutual fund with the flexibility of a stock. Almost anything that can be done with a stock can be done with an ETF. Here, we look at the advantages of ETFs:

1. Investing Flexibility

Because ETFs trade on an exchange, they can be:

  • Bought and sold at any time during the trading day (at intraday market prices)
  • Purchased on margin
  • Sold short, even on a downtick. As such, ETFs can be used as a viable hedging strategy against one's core stock portfolio.
  • Traded using stop orders and limit orders

2. Diversification

The basket-of-stocks philosophy utilized in ETF trading provides diversity that it as deep and wide as an index or sector itself. What's more, the ETF market itself is growing rapidly to provide more and more choices.

3. Tax Advantages

The method in which ETFs are created and distributed means that an investor does not need to dole out capital-gains taxes until he completes the final sale of the ETF in his portfolio. As far as the IRS is concerned, ETF trading is considered to be in kind, as identical items are exchanged for one another (an ETF for the basket of stocks of which the ETF is comprised).

Mutual funds, however, involve the transfer of currency, which effectively signals the tangible realization of capital gains. It may be a technicality, but it's one that works to the advantage of ETF investors. The delay in paying taxes derived from trading ETFs rather than mutual funds can be beneficial for a stock portfolio. After all, the longer money is held onto rather than paid toward taxes, the more money it can accrue via interest payments and additional return on investment.

4. Cost Advantages

ETFs are not actively managed and are therefore less expensive to trade than mutual funds. Below, the chart shows the average expense ratio for ETFs and mutual funds.

*Does not include HOLDRS, which charge $2 per quarter for each 100-share lot
Data Source: Morgan Stanley

"As with any investing vehicle, there are risks. Below are some of the potential risks to be aware of when trading ETFs.

1. Market Fluctuations

  • The stocks tracked within an ETF are subject to the same risks as traditional equities. If the component stocks decline due to weakening fundamentals, crumbling technical support, global events, or any other market fluctuations, the value of the ETF will go down.
  • Fixed-income-based ETFs are subject to the same risks endured by bond traders, such as the interest-rate environment.
  • International ETFs run the risk of capital loss due to currency fluctuations or instability (economic or otherwise) in the nations followed by the ETF.

2. Credit Risk

If an ETF issuer is unable to make payments of principal and interest when due (such as on a corporate bond), the fund's inherent value and ability to pay dividends may be compromised.

"The idea of an ETF entered the investing lexicon in January 1993, when Standard & Poor's introduced the SPY (known as Spiders) to track the movement of the S&P 500 Index. That year, $461 million changed hands on the ETF. By early 2004, the American Stock Exchange reported that the ETF market was worth $167 billion. While total ETF assets are still a mere fraction of the $7.6 trillion in assets devoted to mutual funds, the popularity of ETFs is definitely on the upswing.

"ETFs are a hybrid product that gives investors the benefits of mutual funds along with the flexibility of stocks. This area of the financial markets has seen rapid growth as more and more understand the advantages ETFs offer. Long-term investors and short-term traders alike have found these securities useful. As the popularity of ETFs has grown, so has the liquidity in the market for different options on them, which only adds to ways that you can use them. ETFs are a wave of the future."

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