Episode 104: December 31, 2008
By Laura Adams.
Exchange traded funds or ETFs are becoming popular investment choices. This show will help you understand what they are and if you should consider investing in them.
What’s an ETF?
ETFs are innovative investments that have been around since the early 1990s. One of the reasons for their growing popularity is that they combine the flexibility of investing in individual stocks with the diversity of investing in mutual funds. ETFs allow you to buy an interest in a portfolio of securities with the purchase of just one investment. They’re basically a mutual fund that can be bought and sold just like shares of stock of publicly held companies.
The largest and most well-known ETFs track broad equity indices and therefore offer great diversification to investors. The Standard & Poor’s Depository Receipts is one of the oldest ETFs. The abbreviation for this fund, SPDR, earned it the name Spiders. It tracks the S & P 500 Index and trades under the symbol SPY.
Another popular ETF is called the Dow Diamonds, which trades under the symbol DIA. It tracks the 30 stocks that make up the Dow Jones Industrial Average. These are the largest companies and the most widely held stocks in the United States.
There are four major benefits to investing in these or any ETF. They are liquidity, low cost, diversification, and tax efficiency. Let’s take a closer look at each of these benefits.
ETFs are bought and sold with fluctuating prices throughout the day just like stocks on the stock exchanges. Even though ETFs are a basket of securities, similar in structure to mutual funds, their holdings are constantly updated. This is in contrast to mutual fund valuation, where a buy or sell order is filled only at the end of the trading day. This is because a mutual fund’s net asset value is only updated once a day, after the market’s close.
The second benefit of ETFs, low cost, is an important one. The less you pay in fees and commissions, the more money you have left to work for you. There are no investment minimums or extra sales charges associated with ETFs. You only pay a customary brokerage fee for placing a buy or sell order, just like you would for a stock.
ETFs also have relatively low expense ratios. This means that the percentage of fund assets spent to operate the fund is low when compared to many traditional mutual funds. They stay lean because most ETFs are index funds, and don’t need to be actively managed. The goal of an index fund is very simple—to replicate the price fluctuations of a specific market. This can be accomplished with computer models and statistical sampling, for example, which requires little work on the part of humans. But be aware that not all ETFs use a passive management strategy. It’s important to research and compare expense ratios for any funds that you’re considering.
When you invest in an ETF you get instant exposure to a basket of securities. This is a great way to diversify your investments. There are hundreds of ETFs, each created to address investment choices for various industry sectors, geographic regions, countries, company sizes, commodities, real estate, or broad market indices for example. This allows you to easily build a portfolio with different asset classes and risk profiles that suit you.
The last major advantage of ETFs is their tax efficiency. This is the result of the unique way ETF shares are created and sold. Since ETF shares can only be bought and sold on the market, rapid trading can’t force a fund to liquidate shares. This is in contrast to mutual funds that may be forced to sell its underlying securities in order to raise the necessary cash to pay investors who want to sell. The liquidation of profitable securities or assets can result in a capital gains distribution that a mutual fund must make to its shareholders. I covered the topic of mutual fund taxation in more detail in show 99. If you need more clarification about this topic, be sure to go back and listen to that show.
Are ETFs Right for You?
If you’re investing regularly in a qualified tax-deferred retirement account such as an IRA or 401(k), traditional mutual funds are still great choices for you. Retirement accounts allow you to defer the taxes that could arise from a mutual fund’s capital gains distribution. However, if you’re investing larger amounts of money on a not-so-regular basis, consider that you’ll have lower transaction costs with ETFs. And if you’re investing in a taxable account, you’ll never receive capital gains distributions from an ETF. But keep in mind that whenever you sell mutual fund or ETF shares for a net profit, you always trigger a personal capital gains tax liability.
For more information about investing in ETFs, visit websites such as ishares.com and powershares.com.
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