Exchange Traded Funds (ETFs): ETFs have grown since the 1990’s and have become one of the most popular investment vehicles for both retail and institutional investors. The first ETF was the S&P500 Depositary Receipt often referred to as the “Spider”. Currently, it is estimated that there are over $1 trillion of assets under ETF management.
Exhange Traded Funds are index funds that trade like shares and provide the diversification of managed funds. ETFs can invest in a basket of stocks, commodities or other assets that make up an index or sector. In this way they attempt to replicate the performance of an index.
Investors are attracted to Exchange Traded Funds for many reasons.
Diversification: ETFs offer tremendous opportunities to diversify investments. There are a large number of ETFs available that allow investors to invest in a basket of Stocks, emerging markets, Commodities, Currencies, Bonds, real estate etc. One of the cardinal rules of investing is diversification and ETF investors can achieve this by acting like their own portfolio manager.
Risk Management: Diversification reduces risk. Obviously if an investor places all their money in one company or asset they are taking on a huge amount of risk. Anything can happen to the value of an individual company or asset. However, ETFs spread the risk because they invest in different stocks/asset classes.
Diversification and risk reduction can be achieved by purchasing an ETF like the SPY in order to buy into a basket of US companies. However, the investor is still exposed to the stock market although not as much as if they owned just one stock. To further diversify, they could purchase ETFs on bonds, commodities and real estate.
Cost: Commission charges apply to an ETF trade similar to a broker charging commission on shares. This makes them very cost effective. The trader is gaining exposure to a broad range of assets through one transaction.
Take the costs of investing in the S&P500 which is a stock index tracking share prices of 500 of the largest companies in the US. The SPY is an Exhange Traded Fund that tracks the performance of the S&P. If the S&P is trading at 1500, an investor can buy one SPY ETF at a cost of around $150. This is significantly cheaper for the individual investor than attempting to select and purchase a large number of US stocks in an attempt to replicate the S&P500.
ETFs, then, are like a mutual fund because of the access to multiple assets but the charges for a mutual fund are significantly greater. This is because they are being actively managed by a portfolio manager. Any profits achieved through a mutual fund can be significantly affected by fees and charges.
Liquidity: ETFs can be traded on the exchange like shares. Even day traders can trade them due to the high liquidity. Investors can enter and exit the market with ease. Mutual funds, on the other hand, are only priced once a day, usually at the end of the trading day. Furthermore, there is no minimum investment unlike some other funds. An investor can buy as little as one share if so desired. ETFs can also be sold short if investors believe that prices are due to decline.
Transparency: It is possible for the investor to see the types and amount of assets held in an ETF on a day to day basis. Because of this they are more transparent than many other types of funds.
Tax: Investors need to do their own research but often ETFs are more tax efficient than other types of funds.
Diversity of Strategy: It is also possible to trade leveraged or inverse ETFs if it suits an investor’s strategy. Leveraged and inverse ETFs are a little more complex. The S&P 500 2x Leveraged Daily ETF seeks to double the return on the S&P500. For example, if the S&P rises 1% on a given day, expect the leveraged ETF to rise 2%. An inverse ETF seeks to do the opposite of the index it tracks. For example, the Short QQQ ETF seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the NASDAQ-100 Index.
Some of the more popular Exchange Traded Funds include:
SYMBOL NAME TRACKS
SPY SPDR S&P500 S&P500 Index
EEM MSCI Emerging Markets Index Fund Emerging Market Stocks.
XLF Financial Select Sector SPDR Financial Services Companies.
QQQ QQQ NASDAQ -100 Index
IWM Russell 2000 Index Fund Russell 2000 Index
TIP TIPS Bond Fund. U.S. Treasury Inflation-Protected Securities
EWJ MSCI Japan Index Fund Japanese Equity Market
FXI FTSE China 25 Index Fund Companies in Chinese Equity Market
GLD SPDR Gold Trust Gold Bullion
USO United States Oil Fund Crude Oil
DBC DB Commodity Index Tracking Fund Commodities
BND Total Bond Market ETF U.S. Investment Grade Bond Market
VNQ REIT ETF U.S. Property Trusts
In conclusion, it is easy to see the advantages of Exchange Traded Funds for investors. Be aware that an ETF is designed to replicate the underlying index but there is no guarantee that their performance will be exactly equal. It is possible that they will be approximately the same but not quite exactly replicated. However, ETFs are a tremendous innovation in finance and new ones continue to be launched in the market. As with other asset classes, investors may use Fundamental Analysis, Technical Analysis Indicators and Chart Patterns to aid their decision making when trading Exchange Traded Funds.