ETFs are investment companies that are registered under the Investment Company Act of 1940 as open-end funds or unit investment trusts.
ETFs combine many of the benefits of an index mutual fund with the flexibility of stocks. Like mutual funds, ETFs enable you to invest in a pool of securities in one transaction. And similar to stocks, ETFs are listed on a stock exchange so you purchase them through a brokerage account. ETFs offer stock-like trading features - enabling you to trade throughout the day, purchase on margin, use limit and stop orders and even short-sell. ETFs do not sell or redeem their shares at net asset value (NAV). Instead, the share price is determined by the market. ETFs sell and redeem ETF shares at NAV only in large blocks.
SOURCE: ETF Assets, March2003
# of ETFS -Investment Company Institute, March 2003
The graph shows the rapid growth in ETF assets and the number of available ETFs. Offering flexibility, transparency and low cost, ETFs have quickly become a popular investment vehicle choice.
Benefits of ETFs
ETFs have the potential to offer numerous benefits to investors, including:
- Trading flexibility. ETFs offer continuous pricing and the ability to trade throughout the day, unlike most mutual funds that are traded at the end of the day. An ETF enables you to purchase on margin, trade using limit and stop orders, as well as short-sell -even on a downtick. There are special risks associated with margin investing. Investors may be called upon to deposit additional cash or securities if their account balancedecreases below an account maininance level/percentage. This strategyis notsuitable for all investors.
- Less expensive. In general, ETFs have lower annual expense ratios than other investment products. For example, the average index mutual fund has an expense ratio of 0.74% vs.the average ETF 's expense ratio of 0.46%. Keep in mind that transaction costs of frequent trading can offset the benefits of low expense ratios.
- Diversification. ETFs are index-based and therefore provide broad diversification across securities - and this diversification is available in a single purchase. Please note that diversification does notensure a profit and does not protect against loss in declining markets.
- Tax-efficiency. ETFs offer the potential for high tax-efficiency because they tend to generate fewer capital gains than traditional mutual funds. ETFs are not required to sell securities to meet investor redemptions. Instead, investors interested in redeeming shares sell them on the exchange to another investor. Of course, selling shares may generate capital gains or losses for the ETF investor.
- Transparency. Because ETFs track specific indices, you generally know which underlying securities you 're invested in.
- Fully invested. Again, because ETFs are index-based, they seek to be fully invested in the underlying securities of the index and offer the potential to fully participate in market movements.
Disadvantages of ETFs
ETFs have the potential to offer numerous disadvantages to investors, including:
- ETF shares are subject to risks similar to those of shares of other diversified portfolios. Investment return and principle value will fluctuate so that shares when redeemed may be worth more or less than their original price. Moreover, the overall depth and liquidity of the secondary market may also fluctuate.
- Although exchange traded funds are designed to provide investment results that generally correspond to the performance of their respective underlying indices, the funds may not be able to exactly replicate the performance of the indices because of fund expenses and other factors.
- Also, there are transaction charges associated with trading ETFs that may negate the lower management fees. Mutual funds and ETFs are obliged to distribute portfolio gains to shareholders at yearend. These gains may be generated by portfolio rebalancing or the need to meet diversification requirements. ETF trading will also generate tax consequences and transaction expenses.
Indices are unmanaged and do not incur management fees, cost and expenses, and cannot be invested in directly.
How to Use ETFs
Offeringtrading flexibility and transparency, ETFscan be popular and useful investment vehicles for both individual and institutional investors. ETFs can be effectively used in many types of investment strategies, including the ones outlined below:
- Asset allocation. Asset allocation strategies consider investor goals, time horizons and risk tolerances in the construction of suitable portfolios. ETFs can be a solid building block in an asset allocation program because they provide broad exposure to market segments, making them ideally suited as components of an asset allocation program.
- Harvest tax losses/Tax management. ETFs can play an important role in helping investors better manage the tax consequences of their investments. This strategy is most often used at year-end and comes into play when an investor wants to harvest a tax loss, yet stay invested in the segment of the market represented by that security. How it works: The investor sells the security and takes the tax loss and simultaneously purchases an ETF with similar characteristics as the sold security.*
- Cash equitization. When investors want to invest in the market, but are unable to decide on which specific investment to select, ETFs may provide a convenient "parking spot" for this cash. Called "cash equitization," this investment strategy offers investors an opportunity to use ETFs to put cash to work for them in the market until they make their investment selection - in an attempt to avoid the potential opportunity costs of missing key investment days in the market.*
- Transition management. Investors sometimes employ this investment strategy when switching asset managers. In order to maintain equity exposure, an investor would sell a current investment and purchase the ETF until they select their new asset manager. Once the new manager is selected, the ETF would be sold and the new asset purchased.*
- Hedging risks. Because they can be borrowed and sold short (even on a downtick, unlike stocks), ETFs can make excellent hedging vehicles. ETFs trade in smaller denominations than most derivative contracts, making them potentially more effective for hedging smaller portfolios. Borrowing and short selling involve increased risks and costs. With short sales, you risk paying more for a security than you received from its sales. These strategiesare notsuitable for all investors.
Are ETFs Right for Your Portfolio?
ETFs offer many advantages and disadvantages. ETFs may be particularly attractive for investors who:
- Seek the ability to trade throughout the day
- Want the flexibility to sell short
- Want to be able to place limit and stop orders
- Want to purchase shares on margin
- Are comfortable investing through a brokerage account
- Understand the impact of trading costs
- Are interested in lower management fees
As always, please consult your financial advisor for more information on ETF investing.
( * ) The information provided here is intended to be general in nature and should not be construed as investment advice or a recommendation of any specific security. ETF shares are subject to risks similar to those of shares of other diversified portfolios. Investment return and principle value will fluctuate so that shares when redeemed may be worth more or less than their original price. Moreover, the overall depth and liquidity of the secondary market may also fluctuate. Although exchange traded funds are designed to provide investment results that generally correspond to the performance of their respective underlying indices, the funds may not be able to exactly replicate the performance of the indices because of fund expenses and other factors. Also, there are transaction charges associated with trading ETFs that may negate the lower management fees. Mutual funds and ETFs are obliged to distribute portfolio gains to shareholders at yearend. These gains may be generated by portfolio rebalancing or the need to meet diversification requirements. ETF trading will also generate tax consequences and transaction expenses.