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Since their introduction in 1993, ETFs have become increasingly popular as evidenced by 47% growth in 2004. Assets invested in ETFs in 2005 totaled $264 billion, up from $102 billion in 2002. Historically, ETFs were offered mainly to institutional investors and traders such as investment banks, insurance companies and hedge funds that liked the idea of large holdings in a diversified group of stocks. Today, large asset managers such as Barclay's Global Investors, Merrill Lynch and Vanguard offer ETFs to individual investors.
ETFs represent a way for investors to gain more efficient access to the stock market. Some experts have compared ETFs to index mutual funds, but in reality there is a significant difference. An ETF and an index mutual fund both invest in stocks that are part of a specific-market index, but an ETF usually has much smaller expense charges than an indexed mutual fund.
Traditional mutual funds are actively managed by a fund management team and have significant assets. Investors buy shares in a mutual fund, and the investment team then decides what to buy. Sometimes they make smart decisions, but not always! Index mutual funds differ from traditional mutual funds in that they invest in stocks that track a certain benchmark and have lower expenses. Most are computerized instead of run by a "live" management team. ETFs function in reverse since they begin with index tracking. The large institutions who sell ETFs already own and control millions of shares of stocks so they simply need to compile a basket of these stocks to track an index. When the institution deposits the shares with a holder, it receives a number of Creation Units, which are large blocks of shares, for example 50,000. Institutional investors purchase Creation Units and then divide them up to sell as individual shares in the ETF. At this point, the individual shares may be sold to other investors or Creation Units may be sold back to the ETF. ETFs give investors the actual securities that are included in the portfolio instead of cash. This limited redeemability of ETF shares is the reason that ETFs are not mutual funds. It should be noted that there are 6,300 mutual funds compared to 600 ETFs. Both ETFs and traditional mutual funds make it easy to achieve diversification and both have the potential for capital losses, but ETFs have lower fees and greater tax efficiency. It is essential to compare the trade-offs as different investors require different features.
Long-term and short-term investors appreciate ETF's lower fees.
How do ETFs Work?
When investors purchase an ETF, they are buying a securities certificate that confirms legal ownership of a basket of individual stocks.
Established fund managers (e.g. Barclays, Merrill Lynch or Vanguard) typically have ultimate responsibility for planning and operating the ETF, and must obtain all required approvals from the Securities and Exchange Commission (SEC). The manager receives a small portion of the fund's annual assets as a fee and this is disclosed to investors in the prospectus. These large institutional fund managers already own large baskets of stocks in global markets and are in a position to loan stocks for the ETF creation process.
The next step is to assemble the basket of stocks, which is usually enough to purchase 10,000 to 50,000 shares of the ETF. A custodial bank verifies that the basket does in fact represent the requested ETF and then sends the ETF shares to the participant. The custodial bank is paid a small portion of assets – generally by the fund manager out of his management fees. The exchange does not lead to capital gains for investors since equivalent items are being traded. The custodial bank keeps the basket of stocks in the fund's account and the fund manager is responsible for overall management and oversight.
Stocks and ETF certificates are processed through the Depository Trust Clearing Corporation, which records ETF transfers and watches for fraudulent activities. ETF shares are traded among investors on the open market once the authorized participant obtains them from the custodial bank. When ETF shares are redeemed, the process is conduced in the reverse.
Fees & Costs
Costs associated with ETFs are modest, often as low as 10 basis points (.10% or one-tenth of one percent), and they are clearly specified in the investor prospectus. These low fees may be contrasted to mutual fund fees, which are usually at least 1.5 percent. While the difference between .10 and 1.5 may not sound significant at first glance, it will add up quickly. Competition keeps ETF fees low since if prices deviate from the underlying net asset value of the component stocks, another manager may step in to profit from the difference.
Tax Benefits
ETFs are much more tax-smart than mutual funds due to their structure, and the fact that they allow the investor to have more control over the tax bill. The reason for this is simply that unless a company is deleted from or added to the index, there are no trades within the ETF to create a capital gain or loss. Because an ETF does not make capital gains distributions, the tax bill is impacted only when the investor sells and is required to pay taxes based on the personal gain or loss. With an actively managed mutual fund, however, the investor inherits all of the fund's capital gains and may have to pay the taxes on the capital gains distributions received at a time when he did receive any monetary benefit from the gains. An additional point is that most ETF trading takes place between shareholders which means the fund is not likely to have to sell shares to meet investor redemptions.
Brokerage Requirements
Because ETFs essentially trade like a stock, investors buy and sell shares through a broker and pay a commission each time. Presently there are four(4) major "electronic brokers" charging $7-10 per trade as well as some recent entrys charging as little as $3-4 per trade. This is the reason AFG uses ETF's as the costs keep coming down which leaves more return for the investor(client).
Although ETF transactions do result in brokerage commissions the savings that result from reduced annual fees are much larger than these small costs over the long term. However, brokerage commissions are an important reason why ETFs are not recommended for those who use Dollar Cost Averaging, an investing approach that requires smaller periodic investments, usually monthly. DCA results in a high trading bill and the commissions on the ETF likely will offset any savings that result from the ETF's lower expense charges.(This could change!!)
Trading Flexibility
Mutual funds do not close on any transactions received during the trading day until the market closes for the day, and the price paid or received is the fund's closing price. ETFs, on the other hand, have the important advantage of being able to trade throughout the day and settle in minutes.
Diversification
Diversification is a popular ETF feature that is attractive to investors, especially in volatile markets. It offers investors a means in which to invest in a certain sector of the market without being exposed to single stock risk. Indeed, they present a way to significantly diversify the portfolio.
Investors have the important benefit of being able to lock in prices of component stocks without waiting for the market's closing bell. This is important because prices change constantly throughout the day based on what buyers and sellers are willing to pay at any point during market hours. Investors can sell shares of ETF when they are satisfied with the price instead of worrying about what the market might do between the time they place the sell order and market's close.
Risk Considerations
Investors should expect higher volatility for ETFs that invest in small cap stocks, but may also benefit from greater returns over the long term. Overall, ETFs are as safe as the underlying stock and they are regulated by the SEC, which determines the requirements for buying and selling.
Options Contracts
An individual investor can purchase options based on ETFs that allow him or her to use defensive investing strategies that can safeguard against losses. These options contracts provide the right to buy or sell 100 shares at a set price on a pre-determined expiration date. More than 162 million ETF options contracts were traded in 2004, according to the Options Clearing Corporation, which represents approximately 12 percent of total options volume. These statistics are especially interesting since individual investors have not used ETF options contracts to the extent that hedge funds and institutional investors have used them since their introduction in the 1990's, despite their value as a hedge against ETF holdings.
Index vs. Closed-End ETFs
As stated previously, an index ETF pools investor assets and uses public indexes to invest the money. Unlike a mutual fund, the index ETF is created by institutions depositing securities into the fund in return for creation units and receiving, in return, a set amount of shares that are then traded on a stock exchange. Individuals may buy or sell fund shares on the stock exchange. Common securities strategies such as market orders, limit orders, stop orders, short sales, and margin buying can be used with index ETFs.
A Closed-End ETF also pools investors assets and has professional managers to invest the money. A Closed-End ETF is different in that it issues a fixed number of shares through an initial public offering (IPO). These shares are listed on a national stock exchange, and the investors buy or sell fund shares on the stock exchange instead of directly from the fund. This process is akin to purchasing or selling other listed stocks.
Types of ETFs
The basket of stocks included in an ETF's portfolio is tied to an underlying index, meaning it holds the same stocks as an index. Some ETFs optimize, which means they do not replicate the entire index, but instead follow the index as closely as possible without owning ever single security. Among the most popular ETFs are the SPDR, which tracks the performance of the S&P 500 stock index, and the NASDAQ 100 Trust Series, which tracks the performance of the NASDAQ 100 stock index. Other ETFs are offered that track indexes linked to large-cap stocks, mid-cap, stocks,small-cap stocks,industry sectors,preferred stocks, and foreign stocks.
Fixed-income ETF's for example, are bond portfolios that may be bought and sold like stocks. Like more traditional bond funds, fixed-income ETFs maintain a portfolio that reflects the underlying bond index's target maturity. They may be sold short, traded on margin and hedged with options.
Investor demand is the primary force driving ETF issuance. If a significant investor segment wants a particular country or regional fund, for example, it is likely that such a fund will be offered. Liquidity and transparency of the targeted equity market must be considered, however, since certain areas can present complications (e.g. settlement considerations) for portfolio managers.
Conclusion
Exchange-Traded Funds are an innovative investment product for individual investors who seek both broad and targeted exposure to the stock market at a lower cost than other types of investments. Indeed, ETFs have some of the lowest expense rations among the many investment products now available. Flexibility is an additional advantage that attracts investors who realize the value of being able to respond quickly to shorter-term opportunities. A word of caution—there are many new ETF funds and the volume of trading needs to be large enough if one's time horizon is short or if the position desired is too large for the liquidity available. ETF assets under management will continue to grow exponentially as individual investors increasingly take advantage of the same benefits in ETFs previously available only to large institutional investors.
Arnold Financial Group(AFG) provides financial services to qualified clients. Any discussion of investments and investment strategies of funds (including current investment themes, research and investment processes, and portfolio characteristics) represent the views of AFG at the time of publication. Any expression of opinion is subject to change without notice and are not intended to be a guarantee of future events.
This document is supplied by AFG for information only and does not constitute a solicitation to buy or sell securities. Although information and opinions in this document have been obtained from sources believed to be reliable, we do not warrant the accuracy or completeness and accept no liability for any direct consequential losses arising from its use. The information is representative of AFG viewpoints at the time of publication. Not all products and services are available at all locations and not all instruments are suitable for all investors.
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