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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. |
You may also be looking for the page on Emerging Markets Telecommunications Fund (ETF)
An exchange traded fund is a mutual fund that trades on an exchange just like a stock. Like Mutual Funds, ETFs are regulated by the SEC under the 1940 Act. It holds a pool of assets: stocks, bonds, futures, or even commodities, like gold.
ETFs are built on sound corporate governance principles: Board of Directors, Compensated management, Highly detailed recordkeeping and audit requirements.
An ETF is priced proportionately to the value of the underlying equities it represents. Mutual funds, work by taking the whole pie and slicing it into equal shares. Each share has the same Net Asset Value (NAV).
However, as opposed to actively managed Mutual Funds, ETFs track and hold a known and fully disclosed basket of stocks, usually an index. ETF shares trade directly on a stock exchange. Just like stocks, investors experience commissions and bid/ask spreads. Just like mutual funds, fund sponsors get paid a management fee.
It provides a very easy way for the average investor to get a specific set of equities without the overhead of purchasing each equity separately. 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, ticker symbol IWB, tracks the stocks listed in the Russell 1000 Index. Indeed, plotting the two side-by-side shows a near perfect track in terms of performance (similarly, the iShares S&P 500 ETF, IVV, against the index shown below)
[edit] 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.
[edit] 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 are funds that promise 2x, 3x or , -1x, -2x, -3x daily performance on a certain index. 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.
- 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].
[edit] References
[edit] ETFs on Wikinvest
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