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In the News - Exchange Traded Funds (ETFs)

Exchange Traded Funds, otherwise known as ETFs, have gained increasing popularity, whereby we felt that a brief overview of this investment sector would be a topic of interest for those who were unfamiliar with these investment vehicles.  Feel free to contact your investment professional if you have any questions after reading this material or would like additional information regarding this subject matter. 

An Exchange Traded Fund (ETF) simply represents a basket of stocks that reflect an index such as the S&P 500.  ETFs are often referred to as hybrid securities, because they contain attributes of both Mutual Funds and individual stocks and bonds.  An ETF, however, isn't a mutual fund; it trades just like any other company on a stock exchange.  Also, while mutual funds (excluding indexed mutual funds) are generally actively managed in an attempt to beat an underlying index, an ETF simply attempts to mirror an index. 

ETFs are listed securities and therefore are able to trade on a ongoing basis. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand.  In addition, one can now purchase fixed income ETFs that track a wide range of bond indexes.  Innterestingly, these have the trading characteristics of a stock ETF.  While most individual bonds are held until maturity, bond ETFs don’t have a maturity date and trade to a targeted maturity similar to bond mutual funds.  They pay out interest through a monthly dividend. 

By owning an ETF, you get the diversification of an index fund plus the flexibility of an individual stock. Because ETFs trade like stocks, you can sell them short, buy them on margin, and purchase as little as one share.  ETFs allow you to track hundreds of domestic and international indexes, as well as specific commodities, such as oil, silver, gold, etc.

Exchange-traded funds (ETFs) were first introduced in the United States in 1992, and in 1993, the first exchange-traded fund, the S&P 500 Index fund (nicknamed spiders because of their SPDR ticker symbol), began trading on the American Stock Exchange (AMEX).   By 1999 there were roughly 32 ETFs trading in the US, representing approximately $36 billion in assets.  According to the National Stock Exchange, ETF assets reached $598 billion at the end of October 2007, up 48 percent from $403 billion at the end of October 2006, representing well over 550 ETFs trading domestically.  With well over $670 in ETFs billion trading globally, Morgan Stanley predicts that total assets under management globally in ETFs are expected to top $2 trillion by 2011.

While domestic ETFs attempt to replicate the return of various indexes or baskets of securities, there is no guarantee that they will do so exactly.  However, as ETFs are passively managed, investors are likely to save considerably due to lower management fees.  The expense ratios of most ETFs are lower than that of an average mutual fund and hence the overall cost of owning an ETF is less. When buying and selling ETFs, however, you pay the same commission that you'd pay on any regular stock trade.

Some of the most popular Exchange Traded Funds are listed below with their index symbol:

While many of these ETFs track indices and baskets of securities in a traditional fashion (a.k.a. market capitalization-weighted indexes), some of the newer ETFs have also included alternatives to market cap weighting, such as equal dollar weighted, performance weighted, fundamentally weighted and even dividend weighted strategies.  These new developments in indexing are focused on achieving different investment objectives rather than tracking securities simply to provide exposure to specific securities, a particular industry or country, and oftentimes have an increased risk/return profile. 

What are some of the features that make ETFs an attractive investment?

Low Management Fees.  Management fees charged by ETFs are generally lower than those charged by mutual funds, making ETFs more cost-efficient. Although brokerage commissions apply when trading ETFs, the benefit in lower management fees can potentially offset those commissions.

Performance.  Without high management fees, ETFs can potentially outperform actively managed mutual funds over time. While ETFs are designed to track rather than outperform indices, relatively few active fund managers historically match or beat their fund's benchmarks over the long term.

 

Transparency.  ETFs contain clearly defined baskets of securities that change only when the underlying index does.  ETFs disclose and publish their full portfolio holdins on a daily basis. 

Tax Efficiency.  Because they rarely trigger capital gains, ETFs are generally more tax-efficient than mutual funds. The in-kind transferability structure of an ETF allows it to manage its taxable positions so that there is no taxable gain or loss on transactions, thereby substantially mitigating the risk of capital gains distributions to shareholders.   

 

Intraday Pricing.  ETFs can be bought or sold at any time during the trading day, just like stocks. In contrast, mutual funds are priced only at the end of each trading day.

Fully Invested.  Unlike mutual funds which maintain cash positions and reserves to meet redemptions, ETFs are essentially fully invested, increasing their ability to more closely track an index or basket of securities.

 

Diversification.  ETFs can be purchased in small quantities allowing one to create a diversified portfolio even with a modest amount of assets.

Options.  Many ETFs now also have options, though they often carry substantially more risk than the underlying ETF.

 

Targeted Exposure.  ETFs  provide an effective way to add or subtract a specified amount of portfolio exposure to targeted markets, styles, sectors or investment themes. 

 

Convenient.  All ETFs are held in street name making it easy to buy, sell or transfer ETF shares.

 

The following table illustrates how the attributes of an ETF compare to individual securities and mutual funds:

Attribute

ETF

Individual Equity

Mutual Fund

Management Fees

Historically Low

None

Historically high; industry average 1.44%

Charge 12b-1 Fees

Usually none; maximum allowed is .07%

No

Maximum 1%

Intraday Pricing

Yes

Yes

No

Transparency

Yes

Yes

No

May Be Bought On Margin

Yes

Yes

No

May Be Sold Short

Yes

Yes

No

Control Over Capital Gains

Yes

Yes

No

Pay Dividends

Yes

Yes

Yes

 

At W.B. Smith Companies, we use ETF’s as a way to enhance a portfolio’s flexibility, increase investment opportunities, broaden diversification and add small positions to niche or specialty sector holdings within one's overall portfolio allocation.  They can also be used to hedge portfolios or add contrarian positions as well as to short the market or to quickly increase or decrease market exposure.  ETFs are convenient, cost efficient and offer an increasing number and variety to choose from.  If there are currently no ETFs in your portfolio, there's a good chance that we may consider using them for you in the future. 

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