ETF funds – All you need to know about investing in ETFs

If you are interested in stock market investing, chances are you have heard of, or even invested in, ETF funds.

What is an ETF?

Exchange traded funds (ETFs) have only been around since 1993, when the first ETF was introduced. That original ETF (SPDR S&P 500 ETF, by State Street Global Advisors) is still one of the most popular today. In recent years ETF funds have become increasingly popular as an alternative to mutual funds.

ETFs are low cost index funds that are listed and trade on major stock exchanges, just like stocks. They are made up of a basket of securities, similarly to mutual funds. However, an ETF has its own ticker symbol and can be bought and sold, during market hours – like an individual stock – through your broker (including discount online brokers). (A standard brokerage commission to buy or sell will apply.)

ETFs track a variety of stock, bond, commodity and currency indices. Some ETFs track the performance of a broad index (e.g. the S&P 500, FTSE 100, etc), others are more narrowly focused on a specific sector, company size, or even a country or region.

Why invest in ETFs?

ETFs have become increasingly popular with both individual and institutional investors, as well as traders and other financial professionals. Despite the jump in money flows into ETFs, they are still small compared to the amount of money invested in mutual funds.

So what are the main advantages of ETFs?

• low expenses
• tax efficiency
• diversification -> reduced risk
• transparency, trading flexibility and  liquidity
• instant, low cost exposure to global markets
• exposure to specific sectors, industries, investing styles, etc
• access to long & short strategies

While mutual fund managers try to beat the benchmark index each year, ETFs aim to mirror it.

Which is not a bad thing considered that a vast majority of fund managers under-perform the market averages, and even top managers rarely sustain their excellent returns over time. Trying to outperform the market – especially after fees – is difficult, and most managers don’t succeed.

Most investors tend to be better off buying an index ETF, which is low cost and will ultimately outperform most active managers.

One of the most important decisions for an investor is the right asset allocation for his portfolio. ETFs are well suited here, allowing active investors to easily adjust their asset allocation as markets (and risks) change, increasing or cutting exposure fast.

Since ETFs trade on exchanges, you have the advantage of the same types of trades (long, short) and orders (incl. limit, stop, stop loss, etc) as with an individual stock. Many ETFs also have the capability for options (puts and calls) to be written against them.

The diversification of most ETFs reduces investment risk. Every individual stock is only part of a basket, hence ETFs are generally less volatile than individual stocks.

Importantly, there is no minimum investment requirement, so you can buy as much or as little as you wish.

Expense ratios

Buying and selling fees:

• ETFs – standard brokerage commission

• Mutual funds – between 0 and 5% (on purchase)

Management fees:

ETFs tend to have a significantly lower expense ratio than mutual funds.

• ETFs – annual fees of 0.1 – 1%

• Mutual funds – 1-3% p.a.

(Expense ratios of ETFs vary, so make sure to check each fund’s prospectus.)

You would not believe how much this saving adds up over the long term!

Often investors don’t realize that costs play a huge role in reducing their returns. Commissions, load fees, advisory fees, management fees, taxes, etc… when added up, they will reduce overall investment returns very significantly.

Tax Advantages

One often overlooked issue is the high amount of taxable transactions in most mutual funds. Actively managed mutual funds have high turnover of their portfolio, and more trades result in not only higher transaction fees but also additional taxation. (The tax is deducted from the investors in the fund, even when they don’t sell their shares.) This, along with all the other costs and fees means a significant reduction in a fund’s return.

ETFs are usually more tax efficient than mutual funds. They are generally designed to track benchmark indices, and as such make fewer trades. The low portfolio turnover reduces the frequency of tax gain distributions.

(In the US, whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the fund must distribute capital gains to its shareholders. These gains are subject to taxes, even if you reinvest the distributions in more shares of the fund. ETF investors, on the other hand, only realize capital gains when they sell their shares in the ETF, when the ETF changes holdings in its underlying index or when stocks are removed from/added to the index.)

So instead of looking at the reported pre-tax returns of actively managed funds, compare after-tax returns of available investments before you decide where to put your cash.

(Note that US taxation of commodity ETFs is more complex and varies depending on their structure. Some commodity ETFs own the physical commodity and are taxed at a long term capital gains rate. Others use futures contracts to gain their commodities exposure; these are taxed every year, even if you don’t sell, at a hybrid rate -60% of your gains are taxed at the long term capital gains rate and 40% are taxed as short term capital gains.)

Please note that this is not meant as tax advice and may not be correct at the time of reading. Speak to your tax advisor before making any investment decision.

Who issues ETFs?

There are a number of companies providing ETFs. Among the best known are Barclays Global Investors, Vanguard, State Street Global Advisors, Fidelity Investments, Credit Suisse, Deutsche Bank, Lyxor, and many others.

Types of ETFs

When doing your research on ETFs, read the prospectus and information found on the issuer’s website. There are many different types of ETFs, depending on what the fund is tracking but also how the securities are weighted, whether there is any additional risk exposure, etc. Make sure you understand what exactly you’re buying before you invest.

ETF types:

Index ETF

The most common type of ETF, an index ETF tracks a specific US or foreign stock index (e.g. NASDAQ 100, FTSE 100, S&P 500, Russell 2000, etc). There is a large variety of index ETFs for investors to choose from.

Sector/industry ETF

These ETFs represent a specific sector (industry group), e.g. technology, energy, materials, industrials, healthcare, financials, utilities, consumer staples, etc. They track the collective performance of that industry. As with most other ETF types, there are US as well as foreign and global sector ETFs.

Size-specific ETF

These ETFs are defined by the market capitalization of the individual stocks within. For example large-cap companies (generally over $10 billion in market cap), mid-cap companies ($2 bil to $10 bil), small-caps ($300 mil to $2 bil), micro-caps ($50 mil – $300 mil).

Country-specific ETF

These ETFs track the performance of the markets of an individual country, or, in some cases, an entire region (e.g. Eastern Europe, Eurozone, Latin America, Asia, etc). There are numerous international ETFs listed both on US and foreign stock exchanges.

Commodity ETF

Commodity ETFs track the performance of a commodity (e.g. oil, natural gas, gold, silver) or a basket of commodities (such as precious metals, base metals, agricultural commodities, etc).

As discussed in the tax section above, you need to make sure you fully understand how the commodity ETF is structured. While some own the actual commodity, others are futures-based. Risks as well as tax implications will therefore vary.

Currency ETF

A currency ETF provides investors the ability to track the performance of various currencies throughout the world, such as the US dollar, Japanese yen, British pound, Euro, etc. (It’s important to note that while FOREX is essentially a 24hr market, currency ETFs are available for trading only during stock market trading hours.)

Fixed income ETF

ETFs that track corporate bond or treasury bond indices.

ETFs by weighting model

Equal-weighted ETF

Most ETFs (and indices) are weighted by market capitalization, meaning that larger companies have much greater representation in the index and greater influence on the price movement. Most of the index’s capitalization is concentrated in the top holdings.

A few providers now offer equal-weighted (index and sector) ETFs, which give a broader representation of the companies within the index. Each stock is initially given an equal weight, allowing you to spread your risk equally among all the stocks in the index. It also means you get more exposure to smaller and midsized companies, which often outperform the larger caps.

The other issue with market cap weighting is that stocks that have quickly risen in price and become overvalued will have higher weighting in the index. (The higher a stock’s valuation, the higher is its market cap.) Equal-weighed ETFs avoid overweighting stocks that trade above their fair value.

To maintain equal weighting, the ETF needs periodic rebalancing (generally done on a quarterly basis).

This means that such ETFs (compared to traditional index ETFs) usually have higher expense ratios, as well as higher bid-ask spreads (since they tend to be more thinly traded). As rebalancing involves selling stocks that have appreciated most, it results in higher transaction fees but also higher tax liability (due to realization of capital gains).

While equal-weighted ETFs are a great addition to the ETF universe, they tend to be slightly more expensive as well as less tax efficient, all of which can result in a lower compound return. Investors need to examine carefully whether these ETFs will benefit their portfolio.

Fundamentally weighted ETF

While traditional indices are market cap weighted, fundamentally weighted ETFs offer an alternative, weighting companies based on fundamental factors (such as book value, earnings, dividends, etc).

Some ETFs are weighted to fit a certain investment style. For example, there is a range of value ETFs which select companies based on combinations of price/earnings, price/book, price/cash flow ratios, dividend yield, etc.

As we have seen with equal weighting, ETFs that are weighted other than by market cap tend to have a higher portfolio turnover (since they have to buy and sell holdings as prices fluctuate). This results in increased transaction costs and lower tax efficiency; both generally apply to fundamentally weighted ETFs as well.

Actively managed ETF

Actively managed ETFs have been around since 2008 and have so far not proved very popular with investors. These ETFs, instead of tracking an index, use a manager to select the securities to be included in the fund.

Actively managed ETFs present similar issues as traditional actively managed mutual funds… the expense ratio and transaction costs are higher, and tax liabilities are higher.

Therefore, the manager has to add up enough value to make up for this. Now, as we can see with most mutual funds, that rarely happens. Since most managers don’t do better than market averages, the benefits of actively managed ETFs may be questionable (at least until we start to see some track record of these funds).

Coming in Part II…

While ETFs were first introduced as passive, low-cost, transparent investment vehicles, today there is also a number of highly complex ETFs. Some of them have proved very popular with traders and experienced investors, but it is essential that you fully understand the risks before investing in these more exotic vehicles.

They include leveraged ETFs, short ETFs, futures-based ETFs, ETNs (exchange traded notes), ETFs of ETFs… And we’ll tell you all about them, including the pros & cons and things to watch out for, next week, in Part II of this ETF guide.

In the meantime, if you have any questions about ETFs (or indeed any investments), simply write it in the comment box below and you’ll get an answer asap. (Alternatively you can always write to info (at) moneyhoneyblog.com.)

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This entry was posted on December 15, 2009 at December 15, 2009 and is filed under Featured, How To Guides, Investment, Trading. You can follow any responses to this entry through the RSS 2.0 feed.