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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:

  1. Lipper Inc - available at www.lipperweb.com.
  2. Morningstar - available at www.morningstar.com.
  3. Standard & Poor’s Inc.
  4. 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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