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This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it. |
This page is about Exchange Traded Funds. For the fund with ticker symbol ETF, see the page on Emerging Markets Telecommunications Fund (ETF)
An exchange traded fund (ETF) is an investment product - similar to a mutual fund - that trades on a stock exchange. Most ETFs track major stock indices or industry sub-sectors, which allows investors to get exposure to either the entire market or specific sectors with a single purchase. Unlike a mutual fund, an ETF's holdings - the investments it makes - are always known (its components are simply the weighted components of the index it tracks).
While some mutual funds often aim to "beat" the market or the sector they use as a benchmark, ETFs are typically designed to provide investors with the same performance of the stated benchmark (whether good or bad). Because mutual funds seek to out perform their benchmark, they are described as being "actively managed" (the portfolio managers will make buying and selling decisions based on their views of particular securities in the benchmark), whereas ETFs use "passive management".
As a result, ETFs often charge lower fees than mutual funds, and can be inexpensive ways for investors to invest in the market as a whole or specific sub-sectors. ETFs also have lower expense ratios because they are not actively managed. In most cases, this results in lower management fees and lower turnover costs.
Trading Differences Between ETFs and Mutual Funds
There are some other mechanical differences between mutual funds and ETFs with regards to how they are traded. Mutual funds are quoted shortly after the end of each trading session (and only get one NAV price per day), and typically can't be traded intra-day (buying in the morning, selling in the afternoon). On the other hand, ETFs, however, can be traded intra-day, and some can also be traded in the pre-market and after-hours sessions (note - some ETFs trade 15 minutes beyond normal market hours).
Exchange traded funds hold a pool of assets, the total value of which is divided into proportional shares which are bought and sold by investors via a stock exchange. This provides a very easy way for investors to get a specific set of equities without the overhead of purchasing each equity separately. For example, if an investor wanted to invest $1000 in all the companies in the S&P 500 index, it would be impractical for her to put such a (relatively) small amount to so many securities (she would need to split her $1000 by the weights of each stock in the S&P 500 index). However, by buying shares in an ETF that tracks the S&P 500 Index, she can easily get this exposure by purchasing one security, the ETF.
Tax Efficiency
The construction method of ETFs actually creates a tax advantage for investors when compared to mutual funds. One ETF share is a proportional ownership right for a pool of assets held in the ETF; one mutual fund share is a proportional ownership right for each security in the fund. The difference is subtle, but important. If an investor buys a mutual fund for $10 a share, and sells it 6 months later for $10 a share, she could still owe capital gains on her investment. If an ETF is purchased instead, there would be no capital gains on the transaction. The reason is that the mutual fund investor owns tiny pieces of actual stocks through her fund, so when the portfolio manager buys and sells individual stocks for the fund, capital gains (and losses) can occur without a change in the fund's NAV.
Like mutual funds, ETFs are priced proportionately to the value of the underlying equities it represents. In essence, the fund takes the value of the whole pie and slices it into equal shares. Each share necessarily has the same value. However, unlike mutual funds, which calculate a Net Asset Value at the end of every day, the value of the ETF changes throughout the trading day based on supply and demand from investors; just like a stock, an ETF is subject to the Bid/Ask Spread (however the difference between "true" NAV and the quoted NAV will be very close if the ETF can be sold short).
The makeup of the 'basket' that a given ETF represents is determined when the ETF is established, and cannot change. For example, the iShares Russell 1000 Index Fund (IWB), tracks the stocks listed in the Russell 1000 Index. Plotting the two side-by-side shows a near perfect track in terms of performance.
The issuers and managers of the ETF (called sponsors) are paid a management fee from the fund itself. Though typically small, the amount of the fee varies between funds and may have a significant effect on the difference in value between the fund and it's underlying assets.
ETFs are built on sound corporate governance principles: Board of Directors, Compensated management, highly detailed recordkeeping and audit requirements.
Like Mutual Funds, ETFs are regulated by the SEC under the Investment Company Act of 1940.
Characteristics of ETFs
- Many ETFs have the key benefit of relatively low expense ratios. Because ETFs track a specific benchmark (S&P 500 index, etc.) there is no research team or expensive fund manager to pay to make buy/sell decisions for individual positions in the fund. Thus, ETFs are passively managed funds.
(Note the bid-ask spread on your ETF at purchase: long-term investors can focus on the expense ratio alone, whereas actively trading investors may wish to consider the premium they're paying for a less-liquid ETF like VEA versus the well-known EFA)
- ETFs are more portable than most mutual funds. Portability allows an individual investor to switch financial advisors without incurring the tax cost and transaction costs of selling and buying proprietary mutual funds. Practically all advisor platforms handle ETFs since they trade identically to individual stocks.
- ETFs pass through dividends to investors. Some declare capital gains but most don't. Both open-end and closed-end mutual funds are required by law to either declare at least 95% of capital gains and dividends each year or pay taxes on the gains themselves. Investing in ETFs that don't declare capital gains provides a tax advantage to the investor compared to investing in mutual funds.
Kinds of ETFs
Though commonly associated with stock indices, ETFs can hold any type of asset, including stocks, bonds, futures, currencies, or even tangible commodities such as gold bars. The variety of different "investable" assets means that ETF investors can get exposure not just to stocks, but also to entire asset classes that may otherwise be out of reach. For example, the average investor may not have the risk tolerance, capital, or trading skill to invest in oil futures, but she could easily invest in an oil etf that tracks those futures prices.
- Index ETFs use public indexes as investment benchmarks. Index ETFs are similar to traditional index mutual funds, that allow investors to trade a portfolio of securities in a single transaction.[1].
- Fixed Income ETFs are funds that hold fixed income instruments like corporate bonds, muni bonds, etc.
- Leveraged/Inverse ETFs attempt to achieve returns that are sensitive to market movements. An inverse ETF is designed to perform as the inverse of an index or benchmark. Leveraged and Inverse ETFs are trading tools that give retail investors the ability to carry out sophisticated trades like hedging and shorting which were traditionally only available to large institutional investors allowing for 2x, 3x or , -1x, -2x, -3x daily performance on a certain index.
- Alternatively Weighted ETFs are funds that do not follow a traditional market cap weighting, where the weight of each holding is based on their relative market capitalization, but rather are weighted based on other "fundamentals" like revenue, dividends, etc.
- International ETFs are a way for investors to diversify internationally. Many mutual funds are benchmarked against similar US indexes. For example, Dodge and Cox International Stock fund (DODFX), when measured against US index like the S&P 500 or even large value funds like the Russell 1000 Value Index (the iShares tracker is ticker symbol IWD), DODFX has out performed them.
- By using ETFs to access international equities, investors also gain the flexibility of using these freely traded securities, to enter and exit the international markets at times when they aren't open. There are hidden costs associated with this "artificial" liquidity that are built into the cost of the ETF share itself.
- Finally, US investors are able to enter and exit positions in international equities using only US dollars. There are no conversion fees incurred by first trading currency into the local market currency before investing. Regardless of the currency used for the underlying basket of international equities, the ETF is priced in US dollars.
- Commodities ETFs hold a commodity (or basket of commodities) as their underlying asset, allowing an investor to get exposure to the asset. Commodity ETFs can be attractive for investors who can't trade the underlying physical or futures contracts for the commodity. Commodity ETFs can be "backed" by either the physical commodity itself (a gold ETF stockpiling physical gold, for example) or futures contracts. The choice between a physical and futures underlying ETF can impact costs (storage costs vs. roll costs for futures contracts) and counterparty risk (ideally an investor in a physical gold ETF can get actual gold in exchange for shares; not so for a futures-backed ETF).
- An example of a single commodity ETF is SPDR Gold ETF (GLD), which is designed to provide exposure to the physical gold market.
- An example of a basket of commodities ETF is the PowerShares DB Agricultural Fund (DBA) which is designed to reflect the price change of four of the most widely traded agricultural commodities: corn, wheat, soybeans, and sugar.
- Other types of ETFs include Real Estate ETFs - REITs and Currency ETFs.
References
ETFs on Wikinvest
