Wednesday, May 23, 2012

Exchange Traded Funds

Several online brokerage firms, including TD Ameritrade (100+ ETFs), Fidelity (31 ETFs), Vanguard (64 ETFs), and Schwab (11 ETFs), offer investors the ability to purchase Exchange Traded Funds (ETFs) for zero commissions.  That is not a typographical error.  One may purchase a diversified portfolio of stocks for $0 in commissions.  Before we take advantage of this bargain, let’s make sure we understand the characteristics of this increasingly popular investment.


Why are ETFs so popular?  First, they allow the purchaser to buy shares of a highly diversified portfolio of securities.  Second, there is no minimum purchase, like there is in many mutual funds, enabling the small investor to use their limited resources to diversify across and within sectors.  Third, the expense ratios of ETFs are low, relative to their cousin the “Mutual Fund”.  The average expense ratio for all ETFs is a little more than 50 basis points (bps), while it is over 100 bps for mutual funds.  Fourth, they are relatively tax efficient, as they are designed to mimic an index.  When an index is purchased there are fewer reasons to trade securities which results in fewer capital gain distributions.


What do they do?  ETFs mimic index mutual funds by tracking a broad based index while holding a diversified portfolio of stocks and/or bonds.  ETFs exist for most of the world’s major indices, as well as focusing on specific segments of the stock market.  This “indexing” reduces turnover and, hence, capital gains distributions.  Moreover, low-cost indexing is hard to beat as a strategy, especially for beginning investors seeking to achieve market returns.  For, if you own the market index, you should receive the return on that index, less the expense ratio of the index.


A characteristic of ETFs is that shares are purchased and sold on stock exchanges (hence, we call them exchange traded funds).  This is similar to other common stocks and, with the growth in low-cost internet trading platforms, make it possible to be diversified without having to spend a fortune.  (Zero commissions are pretty low commissions.)  The catch, if there is one, is that the price of an ETF is determined by both the value of the securities held within the fund – similar to other mutual funds – and by market supply and demand factors.  If, for example, there is a either a large increase or decrease in demand for an ETF investment, the price per share could increase or decrease, respectively, according to these external factors.  Another cost is that most stocks are sold on a bid/ask basis, where they are sold at the ask price and purchased at the bid price.  This creates a bid/ask spread which profits the market maker in the ETF.  This could reduce your returns.  These “hidden” stock characteristics, however, also allow for other aspects of stocks to exist in the ETF market.  Practices such as limit orders (set a limit on what you are willing to pay per share) and stop orders (set a price at which your security is sold) are available to the ETF investor, while the mutual fund investor simply buys or sells at the close of the day’s business.  Increasingly, the ability to sell ETFs short and to purchase them through a margin account, allows investors to invest in their beliefs with regard to market moves, as opposed to the moves in a single security. 


Whether you choose an ETF, a mutual fund, or individual securities to invest your money you must never forget the importance of disciplined saving, diversification of investments, and beginning while you are young to work toward your financial success. 


NOTE:  We discussed whether we should continue the Financial Tip of the Week over the summer months of June and July.  Our staff is skeletal during the summer and, as our biggest users are teachers of personal finance, we have decided to suspend publication of the Financial Tip until August.  If you receive it today, you will again receive it in August.  We are just taking a break, while we work on our own Financial Success.


May you have a summer to remember and many blessings within it.


No comments: