One of the most popular investments, to the tune of $820 billion, and least understood is the exchange traded fund. While I have written about them in past blogs I have not defined their value to the average investor.
Exchange Traded Funds have been around in the United States since 1993 and in Europe since 1999. Unlike mutual funds an investor cannot buy an ETF direct but has to purchase one or more of the thousand plus ETFs that are available from a brokerage firm. How much it costs an investor in commission is dependent on the services and the firm. A few discount brokers offer free trades on a select few ETFs but not all. ETFs are also available in some 401k plans and in fee managed accounts.
Don’t confuse ETFs with ETNs. ETNs are Exchange Traded Notes and the difference is one of credit risk. ETNs are structured products and if the organizer of the investment goes bankrupt the possibility exists that the investor in the ETN may not be made whole.
ETFs, or exchange traded funds, have their own mystique and I’ve gotten calls from clients who want to invest in an ETF because they heard you can get filthy rich by doing so. The fact is ETFs can either make or lose money just as any other investment.
Exchange Traded Funds combine the features of a mutual fund (diversification) with the liquidity of a stock where it can be bought and sold throughout the business day. The price of the ETF during the trading day is not exact but more or less close to its net asset price. The actual price isn’t calculated until at the end of the business day.
Commissions are charged just like a stock both on the buy and the sell. There is also an expense fee, just like in a mutual fund, that compensates the ETF manager and organizer. This expense fee varies from one fund to the other. There are 64 exchange traded funds that mimic the S&P 500 index. It not only gets confusing but an investor does need to know what he or she is doing before investing. For example, ETFs are not systematic investment friendly like mutual funds. The commission charged on small purchases will severely reduce potential growth on investment.
The mechanics of an ETF are pretty much simple and straightforward. Just like a stock an investor can short an ETF or even buy an ETF that shorts an index or sector all by itself. There are ETFs that are double and even triple leveraged both on the long and short side of a trade. In other words if you feel small caps will fall you could invest in a triple leveraged ETF that shorts the small cap index. There are commodity ETFs that invest in gold, silver, metals and oil. You can buy ETFs that invest in agriculture. In a previous blog I have written about ETF risk which in some ETFs is called contango where investors can almost be assured of not keeping up with the actual representative commodity because the ETF manager is buying and selling options rather then the actual commodity. (There is a new ETF that says it has solved the contango problem but I have not examined it as yet.)
The true value of an ETF is for an investor to be able to buy and trade a diversified index or sector anytime throughout the day. This ability to be in and out provides mutual fund and institutional managers a convenient option to hedge or diversify a position. It also gives the average investor an opportunity of buying investments that they normally would not have available to them. I am writing specifically about precious metals and commodities. Finally it gives investors the liquidity to sell during the day instead of waiting until 4PM which they have to do with their mutual funds. When markets go south some investors want to get out quickly and not wait for their holdings to possibly fall farther. The ETF gives investors that liquidity. Investors may also set stops on their ETF holdings, decreasing their loss limits.
The positive value of the ETF is for an investor to be able to buy into a position when markets news makes an specific investment very attractive. The ETF also removes the guesswork out of which specific stock to buy because of its sector or index diversification.
Until 2008 all ETFs were indexed or not actively managed. The SEC authorized the creation of actively managed ETFs that year and today there are several. However, because there has not been sufficient time these actively managed ETFs cannot be historically reviewed, compared and analyzed.
The most critical disadvantage of using ETFs in a portfolio are the unknown, untested indexes used by many ETFs.
Still many of my clients can benefit from buying ETFs because:
- Lower cost than mutual funds.
- Buying & selling flexibility.
- Low to no capital gains because of their low portfolio turnover.
- Market specific exposure and diversification.
- Complete transparency of portfolios.
Because of the wide breadth of products now available clients and others should call their advisor or this office to discuss specific ETF needs and solutions.
Questions call Paul @ 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.
No comments:
Post a Comment