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WIKI ANALYSIS
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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 mutual funds often aim to "beat" the market or the sector they track, ETFs usually aim only to track the market and match its performance, good or bad. As a result, ETFs often charge lower fees than mutual funds, and are known as inexpensive ways for investors to invest in the market as a whole or specific sub-sectors.
The fund holds 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 the average investor 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. However, by buying shares in an ETF that tracks the S&P 500 Index, she could gain this exposure at a reasonable rate.
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. This flexibility affords ETF investors exposure not just to broad swaths of stocks, but entire classes of investment that may otherwise be unreasonable; the average investor, for example, may not have the risk tolerance or capital to invest in oil futures, but she could easily invest in an oil etf that tracks those futures prices.
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.
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 1940 Act.
Characteristics of ETFs
- Many ETFs have the key benefit of relatively low expense ratios. Because ETFs follow a set of predetermined rules, there is no research team or expensive fund manager to pay to make active decisions about the contents of 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
- Equity ETFs are funds that hold equities and track an equity index.
- Fixed Income ETFs are funds that hold fixed income instruments like corporate bonds, muni bonds, etc.
- Leveraged/Inverse ETFs A leveraged ETF attempts 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 as their underlying asset, allowing an investor to invest in the commodity. For example, a gold ETF would have physical stockpiles of gold proportional to the value of its outstanding shares. Several ETF fund families such as PowerShares and Adelante Shares have brought out shares which correlate to the price of individual commodities or baskets, such as the PowerShares DB Agricultural Fund (DBA) which reflects the prices of four of the most widely traded agricultural commodities: corn, wheat, soybeans and sugar. Other Commodity ETF's include Real Estate ETFs - REITs and Currency ETFs.
- Index ETFs public indexes as benchmarks to invest the money to meet objectives, such as current income or capital appreciation. Index ETFs are similar to traditional index mutual funds, that allow investors to trade a portfolio of securities in a single transaction.[1].
ETFs on Wikinvest
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