ETFs or Exchange Traded Funds are a fairly new investment vehicle. You have probably seen a lot of publicity about ETFs as they are being marketed and advertised directly to individuals. It is important to learn the facts so that you know how to evaluate these investment vehicles and not be swayed by an advertising campaign.
An Exchange Traded Fund is a pool of securities that you can purchase with one transaction. It is like a mutual fund in that it holds a group of securities and is managed to an investment goal. However, to purchase or sell an ETF, you trade it as you would a stock. Unlike a mutual fund, it trades on a market exchange, allowing you to buy or sell throughout the day. This means that ETFs also have commissions associated with them (although they are sometimes waived as an incentive to get you to trade them) and that they will trade with a bid/ask spread reflecting the market at the time of trade. Also, the pricing will move in response to market activities.
Like their mutual fund counterparts, ETFs will also charge investment management fees. You will want to compare these fees across similar investments. There is competition, and the fees reflect that.
Initially, ETFs had an investment goal of tracking one of the broader market indexes. And there are still broad-market ETFs available. However, as the market has evolved, so have the variety of ETFs. There are over 2,000 different ETFs that are offered in today’s marketplace. That is a dizzying number!
There are almost weekly announcements of new and more esoteric ETFs. You can buy:
- Sector ETFs such as health care, semiconductors, financial services providers and more
- ETFs for foreign market exposure (e.g. India,Brazil, Global Financials, etc.)
- ETFs that hold groups of bonds (e.g. intermediate Treasuries, high yield corporates, mortgage backed securities)
- ETFs that give you exposure to commodities such as gold, silver, agriculture, energy, etc.
In addition, you can buy leveraged ETFs and inverse ETFs! It is a huge array. You have to be very careful to understand what it is you are purchasing and be sure that it meets your need.
While many mutual funds segregate classes of investors, ETFs do not. At any given time in the marketplace an individual, a hedge fund, a professional portfolio manager or a broker could be trading an ETF.
ETFs have a particular structure that allows them to minimize the capital gains that they realize. Of course, this is not a guarantee, as it is dependent on the pattern of transactions in the ETF. But, this structure does allow them to market themselves as tax-efficient. You should note that the strategies themselves are not tax-managed; it is the legal structure that provides this efficiency today.
One of the reasons that people gravitate towards ETFs is the ability to trade throughout the day. If you review our blog from last week, you will see that market timing is not an effective long-term investing strategy. Of course, these trades do generate commissions for the brokers that are facilitating them.
ETFs can provide a way for an investor to gain immediate market exposure. These types of investments tend to be for short-term specific bets or market exposure while making a broader set of portfolio management and allocation decisions.
Since you can trade an ETF by the share, you can get exposure for an extremely small amount. (Not to be repetitive, but you will pay a commission for this trade.) However, for someone starting out this may be a place to learn about investing.
ETFs are also used by hedge funds and other professional managers who trade frequently. These traders are employing a specific strategy and are willing to pay trading costs to execute that strategy. Of course, the buy and hold investors within the ETF, have the privilege of subsidizing all of the hedge fund trading activity!
So, when you see an advertisement for an ETF, Exchange Traded Fund, you now know you should look under the hood. Find out what the investment mandate really is. Is it leveraged? Inverse? Sector? Country? Market? And identify what the fees are. You should also ask what the commission will be to execute a trade in that ETF. You can compare that choice to an alternative investment approach and vehicle, whether it be a mutual fund, a separately managed account or another strategy. Our best advice: Do your research.