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A Short Guide To Exchange-Traded Funds

06/15/05 11:54:48 AM PST
by Paulo Pezzutti

Exchange-traded funds are an interesting alternative for many investors.

Exchange-traded funds (ETFs) have been around for years, but it is only recently they have become popular to the individual investor. Giant asset managers (for example, Barclays Global Investor and Merrill Lynch) are focusing on this market segment and have proposed many new offerings. I'll give you an overview of ETFs, and I will explain why they are suited to individual investors. From the industry perspective, ETFs are a hot topic for rapid growth when aiming at capturing new customers in a very competitive market.

To keep it simple, ETFs are baskets of securities traded on an exchange. They help the investor focus on an asset class. All the major stock indexes, such as the Dow Jones Industrial Average (Djia), Standard & Poor's 500, and the Nasdaq Composite, have ETFs based on them. In addition, there are ETFs for US companies, real estate investment trusts, international stocks, bonds, and so forth. Many asset classes publicly available are represented by an ETF. And the ETF market and availability of new products is still growing.

ETFs can be bought and sold at any time during the day (unlike most mutual funds). Traditional mutual funds take orders during Wall Street trading hours, but the transactions actually occur at the market close. The price they receive is the sum of the closing-day prices of all the stocks contained in the fund. Not so for ETFs, which trade instantaneously all day long and allow an investor to lock in a price for the underlying stocks immediately. They can also be sold short and bought on margin, although retail investors are finding it difficult to short them. Investors can do anything with an ETF that they can do with a normal stock (most of them are currently traded at American Stock Exchange).

Further, ETFs bundle together securities that are part of an index. The expenses that ETFs charge are normally lower than the least costly index mutual funds. As with stocks, you pay a commission to buy and sell ETF shares, which can be a drawback if you trade frequently or invest regularly. There are different ETFs on the market; they are passively managed, tracking a variety of sector-specific, country-specific, and broad-market indexes. In fact, funds rely on arbitrage to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios.

You have to go through a broker to purchase ETFs. They do not trade exactly at the net asset values of their underlying holdings. The ETF price is determined by forces of supply and demand on the market. There are possibilities for ETFs to trade at prices above or below the value of their underlying portfolio. However, the intrinsic characteristics of the market helps keep discounts or premiums low. Arbitrage opportunities generate sufficient assurance for the ETF shares to close the gap between their market price and their net asset value.

As far as liquidity is concerned, you might believe that the liquidity of an ETF is dependent on the fund's average trading volume, or the number of shares traded per day. But this is not the case. A measure of ETF liquidity is of the stocks, which make up the index. ETFs trade like stocks; market makers order the creation and redemption of ETF shares. They build an ETF share from the shares of the companies in the underlying index. They create or redeem shares according to the market demand for them.

Index ETFs: Index ETFs are passive index funds. They allow investors to trade a portfolio of securities in one transaction. These funds offer investors the possibility to trade on domestic indexes such as the S&P, Russell, Dow Jones, and various international indexes. An index ETF can represent a specific sector or industry such as consumer goods, a broad market index, such as the S&P 500, or a specific basket of stocks. Funds may focus also on investment styles such as value or growth. Unlike a mutual fund, an index ETF is created when an institutional investor deposits securities into the fund in return for creation units. In return for the deposit, the institutional investor receives a fixed amount of shares, some or all of which may be traded and priced throughout the day on a stock exchange. The American Stock Exchange was the first exchange to list index ETFs. The New York Stock Exchange and the Chicago Board Options Exchange have recently added these types of funds to their array of products.

There are three main structures for index ETFs, and they are:

·Exchange-traded open-end index mutual fund — This type of fund is registered under the SEC Investment Company Act of 1940. Dividends are reinvested in the fund on the day of the receipt and are paid out quarterly in cash. Funds are allowed to use derivatives and can generate income from loaning securities.
·Exchange-traded unit investment trust — This type of fund is also registered under the SEC Investment Company Act of 1940, and must replicate their benchmark. Several funds deviate from the exact holdings of the underlying index because of the diversification rules of the 1940 act. Dividends are not reinvested in the fund and are paid out quarterly in cash.
·Exchange-traded grant or trust — This type of fund is not registered under the SEC Investment Company Act of 1940, although this structure is the most similar to actually owning the underlying shares of the fund. The composition of the fund does not change, other than to account for corporate actions. These funds can be redeemed for the underlying shares, and investors have voting rights to the underlying securities. Dividends are not reinvested, but are distributed directly to the shareholders.

Closed-End ETF: A closed-end ETF (CEF) invests in securities such as stocks and bonds. Capital raised through an initial public offering is invested according to the fund investment objectives. A closed-end ETF has a board of directors that appoints a portfolio manager. Traditional open-end mutual funds issue and redeem shares directly with investors at net asset value.

Closed-end ETFs shares, listed on a national exchange, are purchased and sold in transactions with other investors. An open-end mutual fund creates new shares every time an investor invests in the fund, and redeems the shares when an investor redeems the fund shares with, as a result, a fluctuation in the number of shares and total assets. When an investor purchases or sells shares of a closed-end ETF, it is done on an exchange such as the NYSE or AMEX. The shares of a closed-end ETF remain constant. However, additional shares can be created through secondary offerings, dividend reinvestment, or rights offerings.

ETFs have several advantages, such as low annual expense ratios; tax-efficiency; they can be traded throughout the day; they allow diversification; and they allow sector-specific investments.

Nevertheless, they aren't suitable for everyone. I personally believe that ETFs are an excellent way for an individual investor to enter the marketplace. Low commissions and the possibility to reduce risk through diversification are very important when planning your investment. The flexibility is provided by the fact that you can buy and sell any time of the day, which allows for short-term trading. Most of all, you can invest in many different sectors and markets by buying an index. That means that you follow the index fluctuations passively.

Actively managed funds have higher commissions and, more often than not, they perform worse than the benchmark. This is because there is normally a costly management and marketing fund structure and often their strategy is flawed. When I buy a mutual fund, I do not know if the manager has a good strategy. Actually, I do not even want to know. But when I buy an index, I'm quite sure that my performance equals that of the index. Through diversification, I can optimize my risk exposure in several different markets at low costs.

In terms of annual expenses charged, ETFs are less expensive than most mutual funds. But this is not true for all of them. Moreover, you pay commissions to buy and sell ETFs, just as you would for stocks. If you plan on making a single investment, then it may pay to choose an ETF. However, if you invest regular sums of money, it will be more expensive to buy ETFs than investing in a mutual fund. Trading frequently would be less expensive with a regular mutual fund, although most mutual funds discourage this practice. Basically, you have to know your investment style or plan and decide accordingly to determine the best tool for you. What I like the most is the possibility provided by ETFs of downplaying stockpicking in favor of buying the market.

With a mutual fund, investor selling might require managers to sell stocks to meet redemptions. The fund has to keep cash to meet redemptions. Trading in ETFs takes place between shareholders, and there is no need for funds to keep cash. ETFs are in general more tax-efficient than mutual funds, but they also can and do make capital-gains distributions.

Some popular ETFs are:

· Standard & Poor's 500 Index Depository Receipts (SPY:AMEX): This popular ETF, commonly referred to as Spiders, tracks the S&P 500, and is considered a standard for measuring large-capitalization US stock market performance.

· Nasdaq-100 Index Tracking Stock (QQQ:AMEX): Tracks the Nasdaq-100 index, which includes 100 of the largest companies listed on the Nasdaq stock market based on market capitalization. It is widely perceived as a technology benchmark.

· DIAMONDS Trust (DIA:AMEX): This ETF tracks the DJIA, a benchmark of 30 blue-chip stocks selected by The Wall Street Journal. The index is still very popular and it is a standard for tracking large traditional US companies.

· iShares S & P 500 (IVV:AMEX): As SPY, this Barclay's ETF tracks the S&P 500.

· Standard & Poor's MidCap 400 SPDRs (MDY:AMEX): This ETF tracks the S&P MidCap 400 index, which measures the performance of the mid-size company segment of the US market and complements the S&P 500.

· iShares Russell 2000 (IWM:AMEX): It tracks the Russell 2000 index, a popular benchmark for mid- and small-cap companies. The Russell 2000 index represents the second tier of US equities, or companies with market values between $20 million and $300 million, which account for approximately 8% to 9% of the total market.

· iShares MSCI Japan (EWJ:AMEX): The iShares MSCI Japan Index Series is an exchange-traded fund designed to closely track the price and yield performance of publicly traded securities in the aggregate in the Japanese market, as measured by the MSCI Japan Index.

· Total Stock Market VIPERs (VTI:AMEX): The Vanguard Group's ETF tracks the Wilshire 5000 broad market index, which is one of the broadest indexes for the US equity market, measuring the performance of the majority of all US-headquartered public companies.

· iShares SmallCap 600 (IJR:AMEX): This ETF tracks the S&P SmallCap 600, which measures the performance of the small-capitalization US companies.

· Energy Select Sector SPDR (XLE:AMEX): The Energy Select Sector SPDR Fund is an exchange-traded fund designed to replicate the price performance and yield of a specific Select Sector Index. The S&P Energy Sector contains companies involved in developing and producing crude oil and natural gas, and provide drilling and other energy-related services. There are nine Select Sector SPDR Funds and collectively represents all of the companies in the S&P 500.

This list is by no means exhaustive. It is just an example of some popular ETFs that are available. There are also more specialized ETFs. An example of ETF classification is as follows:

·Large Cap
·Total Market
·Mid Cap
·Small Cap

As an investing option, ETFs certainly have benefits. They are flexible and low-cost, more tax-efficient than most mutual funds, and address specific sub-sectors that mutual funds do not. Nevertheless, the cost advantage of ETFs isn't always as large as it may seem. For example, if you want to track a broad index such as the S&P 500 or if you wish to invest regular sums of money, one of the existing low-cost mutual fund options may be a better option. Essentially, ETFs are one more option provided to the investor to enter the marketplace. It is important to know what they can offer before you can determine if they are suitable to your investment style and objectives.

Paolo Pezzutti is based in Rome, Italy.

Paulo Pezzutti

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