Tuesday, June 12, 2007

Exchange Traded Funds for Beginners

A relatively new product of the financial services industry has been getting a lot of publicity lately. That's the exchange traded fund, or ETF. The ETF is type of mutual fund that you can buy or sell while the stock market is open. By contrast, traditional mutual funds are bought or sold only after the stock market closes. (You can send in an order for shares of a traditional mutual fund any time, but the order will be filled only after the market closes, at a price based on the closing prices of the stocks and/or bonds that the mutual fund holds.) Although ETFs have been around for about 15 years, they have attained widespread popularity only recently. If you're unfamiliar with them, here are a few basic points.

1. ETFs generally have low costs and expenses, but you have to buy them through a stockbroker. That means you pay a commission. In addition, ETFs have two prices in the market: the "ask" price at which you buy them, and the "bid" price at which you sell them. The "ask" price will be higher than the "bid" price, and the difference between the two--called the "spread"--is a cost of investing. That's because if you buy at the ask price and immediately sell, you'll lose some money from selling at the lower bid price.

Consequently, ETFs are not always the lowest cost product. A low-cost traditional mutual fund may actually be cheaper, because you can buy it without paying a commission or incurring the "bid-ask spread" as a cost of investing. If you're saving small amounts at a time (e.g., $100 or $200 a month), a traditional mutual fund is a cheaper way to invest than an ETF.

2. ETFs are based on market indexes--in other words, the stocks or bonds they hold are the same ones that comprise a market index. For example, an ETF that mimics the S&P 500 will hold the 500 stocks in that index. ETFs started off with broadly based market indexes, like the S&P 500, and were often good choices for long term investment. However, more recently, ETFs have been created to represent increasingly narrow sectors of the stock markets--like just telecommunications stocks or stocks of one particular country. The narrower the index, the more risky the ETF, because it is less diversified. It may provide excellent returns, or terrible losses. The more you invest in narrowly-based ETFs, the more attention you'll have to pay to the overall diversification of your portfolio. In other words, the more work you'll have to do managing your money.

3. ETFs are often tax efficient, in that they are not required to distribute capital gains each year to investors. Investors report gains on their tax returns only when they sell their ETF shares at a profit. But a carefully managed mutual fund can also achieve a high degree of tax efficiency.

4. ETFs theoretically should trade at the same price as the aggregate prices of their underlying assets. This, however, doesn't always occur. Variations in supply and demand at any particular moment can cause an ETF to trade at a discount or premium to the value of its underlying assets. In addition, technical market problems can cause pricing problems. Trades that occur in the underlying stocks and bonds necessarily are reported after they occur. There is always a time lag between trade prices of the underlying assets and the trade price of the ETF. While the time lag may be minor in normal market conditions, when things become hot and heavy, trade reporting in the underlying assets may become delayed, and discrepancies between the value of the underlying assets and the price of the ETF can occur. If this happens, you could pay too much (or get a bargain) on ETF shares. Conversely, you might sell at a price that either is too high (good for you) or too low (bad for you). But, because you won't know about the trade reporting problems, you won't have any idea until after-the-fact whether you got a good or bad price.

5. You can trade an ETF like a stock. In other words, you can own it for minutes, or even seconds, and then sell it. You can sell it short, buy it on margin, use a limit order and the like. Some people may be tempted to trade ETFs short term because they have so many trading options. Stock brokers may encourage such short term trading because it generates commission income for them. However, the history of the stock markets teaches that short term trading generally is less profitable than long term buying and holding. Indeed, many people lose money, rather than make it, when engaged in short term trading. Be cautious using ETFs for short term trading. With their commission expenses, the bid-ask spread, interest charges on margin debt and the risks of trading short term, ETFs probably offer the typical individual investor few advantages, if any, for short term trading.

The ETF is a good long term investment option. If you buy and hold it, you get the most out of it. If you trade ETFs short term, you might money. But you might lose it. You wouldn't use a spoon to eat a steak. Don't use an ETF in ways that aren't likely to help you.

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