ETFs, also known as Exchange Traded Funds, are investment vehicles traded on stock exchanges. They are similar to mutual funds because they offer an undivided interest in a pool of financial securities; however, they are able to be traded by individual investors rather than having to be handled by a fund manager (except in special cases with authorized participants, or large institutional investors).
ETFs hold assets like stocks and bonds, and they trade at approximately the same price as the net asset value (NAV) of its assets during the trading day. Like mutual funds, they offer low-cost benefits, but also incorporate many stock-like features (ex. trading throughout the day), making them rather popular investment options for those looking for both options.
The History of ETFs
Unlike the long history of stocks, ETFs really haven't been around that long. They got their start in 1989 with Index Participation Shares, which is an S&P proxy that traded on the American Stock Exchange and Philadelphia Stock Exchange. The product was short-lived, yet was reborn after Canada was able to maintain a similar product. In 1993, it was re-introduced through Standard & Poor's Depositary Receipts (SPDR). This fund became the largest ETF in the world.
Basic Facts about ETFs
As mentioned previously, ETFs are similar to mutual funds in many ways; however, there are some significant differences. For one, most ETFs have a lower expense ratio than mutual funds (0.1% to 1% for ETFs and 1% to 3% for mutual funds). Also, while mutual funds often have to pass on capital gains to their holders, ETF capital gains are controlled by individual investors, allowing room for more tax efficiency.
There are currently only a handful of major players in ETFs; they are State Street, Vanguard, Powershares, Rydex, and Barclays. These companies account for 75 percent of all ETF assets. This may be because the industry itself is still relatively small. In fact, at the end of 2007, assets in U.S. ETFs held at just over $600 billion. On the other hand, mutual funds held $12 in assets.
What Types of Financial Securities Do ETFs Offer?
You can find the same types of financial securities that would be available through mutual funds. Some of those include:
- Stocks. Stocks are securities distributed through companies that provide a share of ownership in that business.
- Bonds. Bonds are securities that are issued through companies or the government. They give the bondholder the right receive interest in fixed intervals, as well as repayment of the principal balance at a predetermined date.
- T-Bills. Also known as Treasury Bills, these government-issued certificates are issued at a price less than face value so that after they mature they can be paid at face value. They are considered money market instruments.
Investors are often surprised to learn that in addition to investing nationally, they can also participate in foreign ETF trading. This is especially beneficial to those who have recognized that the U.S. dollar is weakening. Trading in foreign ETFs helps investors diversify their portfolios and can increase their reward ratio. Of course, it's good to remember that some countries bring higher risks than others, so research before investing in one over another - or think about investing in an entire region instead.
Advantages and Disadvantages of ETFs
Like any other form of investment, there are some advantages and disadvantages of ETFs. Some advantages include:
- Cost Effectiveness. On the whole, ETFs are generally more cost effective than mutual funds, providing a lower expense ratio.
- Flexibility. ETFs also provide flexibility. Because they are traded on the stock exchange, investors can trade any time of the day during trading hours, rather than at the end of the day with mutual funds.
- Long-Term Interest Not Compromised. Because the trading schedule is more frequent for ETFs, they are not forced to wait until the end of the day where they must trade big stocks and suffer major fees. Instead, trading throughout the days offers more flexibility and lower fees, which helps the interest rates for long-term investors.
- Low Tracking Error. Since ETFs are traded on a real-time basis, they have low tracking errors as compared to index funds.
- Convenience. ETFs are as easy as trading stocks, making investing easy for those already skilled in the stock market.
- Tax Benefits. You don't have to worry about unexpected capital gains or losses with ETFs. Instead, you just sell when it makes the most sense to you tax-wise.
Some disadvantages of ETFs include:
- Demat and Trading Account Required. Because you're essentially trading on the stock market, you must have a demat and trading account with a SEBI-registered stockbroker. This could be a deterrent for those who don't normally invest in stocks, and if these terms don't make sense to you, ETFs are probably not your investment.
- Market Spread. Buying rare ETFs can sometimes result in too wide a buy/ask spread. However, this can be avoided by dealing with major ETFs.
- Disadvantages of Index Funds. Since ETFs are similar to index funds, they follow the index blindly, meaning it may hold shares of stocks you may not like but happen to be in the index.
- No Dividend Reinvestment Plans. Unlike mutual funds that allow investors to have their dividends automatically reinvested, ETFs are too hands-off for this. However, some brokerages do allow their investors to use dividends to offset no-cost purchases back into the ETF.
- Offsets. While mutual funds lend out securities on margin in exchange for payments that can offset the expenses of the funds, ETFs don't lend out securities.
- Too Simple? Because trading is so simple with ETFs, you may find yourself buying and selling, only to realize later that you may have moved too quickly.
Are There Risks With ETFs?
There are a few risks associated with ETFs. One is that the ETF you're associated with may not always hold the types of stocks you expect. It may be advertised one way, but when you dig deeper, you realize that other "stuff" has been thrown in that you didn't anticipate. Also, you have to be careful of wide market spreads.
Are ETFs a Good Investment for Families?
Like mutual funds, ETFs are basically sound investment options for families. Because they're tax efficient and low cost, and also offer diverse options, you can make good choices along the way. However, since you are not using a fund manager and doing the work yourself, there is more room for error, and more time needed for research, which could take away from family time, so keep this in mind.
ETFs are options that many consider because of all of the benefits that they offer. However, before you jump in and begin investing, it's good to make sure you have weighed all of your investment options first to make sure this is truly the route for you.
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