Exchange-Traded Funds

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1 Exchange-Traded Funds Exchange Traded Funds (ETF s) are becoming popular investment vehicles for many investors. Most ETF s are cost effective, broad market funds. We have put together a layman s explanation of exchange-traded funds along with the different indices that can be tracked and be incorporated into an investor s portfolio. ETF s are normally invested in the stock or bond markets and therefore have all of the market risk associated with investing. An owner of an ETF can lose money. These can be risky investments. This paper will include some of the advantages and disadvantages of an ETF. These lists are not exclusive and you should discuss your particular circumstances with your advisor and the ETF prospectus. The Basics ETFs, short for exchange-traded funds, attempt to follow the performance of a specific index. For example, an ETF could track the S&P 500. They are a special breed of a mutual fund and come under the Investment Advisory Act of 1940 rules and regulations. Since ETF s trade on an exchange, their share price is affected by the supply and demand for shares in the market and the value of the underlying shares of stock being held or tracked. ETF s may mirror an index, basket of shares or commodities. A single ETF share is equal to a basket of shares that can include, for example, 10 shares of XYZ, 1000 shares of ABC, etc. In more common ETF s, if the index goes up by 1% then the share price will increase by 1% adjusted for fees. If the index goes down by 15% the ETF goes down by 15% adjusted for fees. Indices do not reflect any fees and there are fees for trading, custody, tracking and management. Individual investors can buy ETF s through an exchange, just like the purchase of stock. ETF s can be traded throughout the day from when the market opens until the market closes. When the fund is purchased through a broker, a brokerage commission fee must be paid at the time of purchase and selling of ETF shares. An ETF can be purchased through a registered

2 investment adviser and a fee will be paid while some ETF s can be bought directly from an exchange. Advantages Most ETFs are simple, inexpensive, liquid, and offer diversification. An investor does not have to wait for a valuation point, so the ETFs can be bought or sold at any given time of day that the market is open. Unlike a mutual fund, there is no fund manager making investment decisions as an investor moves their cash flows in and out. A computer program monitors the underlying holdings, e.g., shares of stock, bonds, or a commodity like gold. ETFs can be sold short, bought on margin and may have low or little minimum investment requirements, allowing the investor to purchase only one share while still having exposure to many different stocks. ETFs are normally based on a relevant index rather than an individual company, which can help spread the risk within a specific sector. ETF s provide an easy way for an investor to gain access to the index, commodity or basket of securities, without having to buy the positions in every single component. ETF portfolios can be modified to amplify various special interests. For example, a broad based international ETF could have enhanced positions in the European markets by having a supplemental European ETF purchased as well. Many ETF s follow an index, so there are few trades or turnover within the portfolio. Therefore, they may have more favorable tax treatment since stocks held will most likely be held for long term capital gains. This may not be true for a managed mutual fund that has high turnover. This allows the ETF to be favored in an after tax portfolio since the sale will follow normal long or short term capital gain rules without surprise tax implications from a managers actions throughout the course of the tax year.

3 Disadvantages Even though ETFs have many advantages, they also have several disadvantages. A client must evaluate his investment goals before deciding on the appropriate ETF. An ETF are risky investments and can and have lost money. The difference in the bid-ask price (which is explained below), may be too great to create ideal profits. Tracking errors can occur in an ETF. Tracking errors arise when not all shares of the index are held in the ETF, which in turn, will not exactly replicate the performance. Some ETF s do not physically hold the underlying asset, so it does not actually own the stock. It may create an artificial position, like holding a derivative, deriving its value from something else. The ETF must have a Principal that can provide the underlying stock for sale. This is another source for tracking error, but it also means taking a greater risk. When ETFs are harder to track, they are more complicated meaning more costs to the client. An ETF has a three day liquidation period so obtaining the cash from the sale of the security may be delayed longer than a corresponding mutual fund or stock. Uses Advisors are using significantly more ETFs when managing an individual s portfolio. ETFs are listed on major exchanges and can track broad markets, e.g., S&P 500 index, specific sectors such as pharmaceuticals, commodities (gold), and foreign markets (China). They can also be used for hedging, speculating, and ordinary investments. Certain ETFs can be bought to suit a client s objectives and the risk they wish to take on. ETFs can also increase one s exposure to a specific market where there are gaps in an individual s portfolio to make it complete. With the majority of trades of stocks generated electronically, with algorithmic formulas, buying and holding individual stocks can become more risky. The ETF s allow investors a broader exposure to the market.

4 Choosing the Right ETF When considering making an investment in ETFs, you should carefully analyze your objectives, risks, and expenses. After choosing which asset class you wish to invest in, there are a few things you must look at when researching which ETF is best. First is the expense ratio, which is the percentage of fund assets deducted to cover fees. Lower expense ratio does not necessarily mean best performance but it may have an impact if two like ETF s are compared. For example, if ETF One and Two are designed to mirror the S&P 500, and ETF One has a half of one percent more in fees, an investor may assume that the performance for ETF One will be less than ETF Two. The trade commission, the fee paid every time an investor buys or sells an ETF, should be determined. Some brokerage fees are higher than others. Look for the funds that have lower fees or commissions. For those ETF s traded on the open market, the bidask spread, which is the difference between the ETF price that an investor is willing to pay and the ask price that the seller is willing to accept should be determined. An investor should also review the fund s total assets under management; it will include the amount of money that has been already invested in the ETF. A smaller fund may have liquidity issues as well as greater tracking errors. Look at the average number of shares that are traded daily. This will provide a liquidity gauge. Lastly, research how the ETF s returns compare to the index returns; if it doesn t follow too close, then this could be a potentially risky investment.

5 Best of Both Worlds An ETF has some properties of stocks, and some properties of an index based mutual funds. An investor can have the best of both worlds in one investment. Like ownership of stock, ETFs have limit, market and stop-loss orders, which can be ideal for controlling your losses. Stocks can be traded on exchange throughout the day, providing the advantage with portfolio flexibility. ETFs can include a basket of securities designed to track a benchmark like an index mutual fund. They have low expense ratios, some with single digit basis points and are tax efficient, increasing an investor s net return on the investment. Most ETFs are open-ended investment companies (mutual funds), a type of company that allows investors to pool together assets, with opportunity to purchase or sell shares on request. Wrap Up An ETF s past performance has no guarantee towards its future results. Even though ETFs do not suit everyone s portfolio, the mixture of tax efficiency, competitive fees, and diversification can combine for a significant advantage over other investment options. Investors must remember, however, that the underlying investments are in the market and can be risky and lose money.

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