Exchange-Traded Fund (ETF)
ETFs (Exchange Traded Funds) are passively managed trading instrument that track major stock indices.
Exchange Traded Funds (ETFs) have been in use since the beginning of the 1980s but they have become more popular with investors in the last decade. When you invest in an ETF you are investing in shares of a portfolio that is tracking an index such as the S&P 500 or the Dow Jones.
Exchange Traded Funds
Tracks the performance of an index. ETFs give investors the ability to diversify over an entire sector or market segment, in a single investment. ETFs allow investors to passively manage their investment portfolio. The ETF matches a market index and so the investor only need to tweak it periodically to keep it in line with its index. This type of management is different from active management because in active management, the investor is competing actively to outperform the market.
ETFs are traded just like a stock. Mutual funds are priced after the market closes but an ETFs price changes constantly during the trading day depending on market fluctuations. ETFs are flexible assets. They can be purchased on margin or be sold short and can be held as a long term investment. The value of an ETF is founded on an underlying index. It is invested in a broad base of stocks and invested in various asset types, sectors and markets. ETFs are extremely liquid, as they are a basket of stocks based on a major index, that trade at high volumes.
An ETF simply matches or tracks an index and doesn’t try to outperform the market. An ETF has less administrative costs than mutual funds. Costs are in the range of 0.25% compared to over 1% with mutual funds. Lower costs increase the profit returns of an ETF.
Passive management of ETFs means that they are more tax efficient investments. There is less potential for capital gains allotments as there are fewer transactions in or out of the fund. This is a primary reason why ETFs have become such a favorite investment vehicle.
ETFs are a valuable component of any investor’s portfolio. Many investors use ETFs as a primary investment tool for their portfolios and can create a well-diversified portfolio, with a few ETFs. Other investors use ETFs to complement their portfolios and implement more sophisticated strategies.
Investment in an ETF and an index mutual both track the same index and would be considered equivalent investments.
Index mutual funds are available for most of the major indexes. ETFs cover a much wider range of indexes with many more investing options.
The first ETFs tracked broad market indexes but recently ETFs have been made available to track sectors, fixed income, global investments, currencies and commodities.
By mid 2012 ETFs had a worldwide trading asset base approaching 1.5 trillion dollars
ETFs can be compared to mutual funds:
Both mutual fund and ETF have an investment structure that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives for current income or capital appreciation.
Popular Families of ETFs
Standard and Poor’s depository receipts (SPDRs) are managed by State Street Global Advisors (SSgA). The most popular SPDR is the SPDR S&P 500 EDF (SPY).State Street Global Advisors also has a series of ETFs that track the major S&P 500 sectors. They are called Select Sector SPDRs.
The iShares family of ETFs are branded and managed by Barclays Global Investors. Barclays is the largest providers of ETFs in the world, providing a diverse offering of ETFs covering broad-based U.S., international, industry sectors, fixed income and commodities.
VIPERS ETFs are issued by Vanguard, better known for their diverse selection of index mutual funds. Vanguard Index Participation Receipts(VIPERs) offer a number of different ETFs, ranging from broad-based to industry sector as well as international and bond ETFs
The PowerShares family of exchange traded funds area relatively new provider of ETFs that offers equity ETFs representing broad market, industry sectors and international indexes as well as fixed income, currency and commodities. The family, which offers the very popular QQQQ, or Nasdaq 100 ETF, also has a number of quantitatively based ETFs developed by using “dynamic indexing”, which constantly searches for the best performing stocks within each index.
How to trade ETFs?
If the price for UK100 index is 5476/5478, and you decide to buy 1,000 shares at the 5478 offer price. But instead of paying the full amount of the shares (£30.00 x 1,000), your broker allows you to trade on a margin you are only required to pay 10% deposit or £3,000.
After the publication of positive data in the UK, the price for UK100 stands at 5551/5553 and you sell to take your profit.
Bought in at: 5478
Sold out at: 5540
Difference: 0.62 pence
Profit 0.62p x 1,000 = £620
A handsome profit of £620 was earned on the ETFs. Minus sales commissions of course.
ETFs can be bought and sold on a stock exchange during the trading day. ETFs trade like stocks and you can buy them just as you would stocks. They can also be sold short.
ETF pays out dividends quarterly. Many ETFs have options, that can be traded for the more sophisticated investors.
ETF Tax Liability
ETFs are passively managed portfolios and they offer greater tax benefits than normal mutual funds. They also generate fewer capital gains due to much less turnover of the securities thus they realize fewer capital gains than actively managed funds. An index ETFs only sells securities to reflect changes in its underlying index.
ETFs have low annual fees when compared to traditional mutual funds. The passive nature of index investing, reduced marketing and distribution and accounting expenses all contribute to the lower fees. Individual investors will have to pay a brokerage commission to purchase and sell ETF shares.
The SPDR ETF tries duplicate as closely as possible the S&P 500 Index.
Investor could buy the SPY as a core portfolio holding to provide exposure to the U.S. stock market. Investor could combine this with other ETFs such as a small cap ETF, value-based ETF or sector ETF to customize their exposure to U.S. stocks.
Equity Index ETFs
ETFs was first developed for diversified portfolios based on equity indexes as a core asset class.
Total market ETF can be used for long-term investor to cover U.S. equities
Sector ETFs can be purchased to investing the stocks of different industrial sectors. Investors can use sector ETFs as building blocks for a portfolio. This can provide for more fine-tuning of a portfolio. Another advantage is rebalancing a portfolio on a regular basis. Selling those sectors that have outperformed and buying those that have underperformed. Sell high and buying low is a strategy that can improve performance.
The stock market is divided into large cap, mid cap and small cap stocks. Instead of buying a broad-based ETF, investor can fine tune their strategy by buying large cap, a mid cap and a small cap ETFs. This provides greater customization for a portfolio.
Fixed Income and Asset Allocation ETFs
ETF Funds have branched out into bond ETFs and asset allocation ETFs, such as those that contain different asset classes. Bond ETFs pay out interest by way of a monthly dividend and capital gains are paid out through an annual dividend. These dividends are treated as either interest income or capital gains for tax purposes.
Broad Based Bond ETFs
Investors can buy a broad based bond ETF containing a general mix of government and corporate bonds with different maturities. Broad based bond ETFs can be core component of a bond portfolio.
Yield Curve Bond ETFs
Many bond funds give investors the option to buy treasury bonds based on different maturities along the yield curve. Longer Treasury ETFs are good for betting on changes in interest rates and short-term bond funds are a ideal place to park money that provides a better return than money market funds.
Inflation Protected Bond ETFs
(TIPS)Treasure Inflated Protected Securities bonds pay interest equal to the CPI (Consumer Price Index) and an added premium. They are principally used as a hedge against inflation and are designed to outperform regular bonds when inflation is expected to rise.
Asset Allocation ETFs
ETFs that contains investments in different asset classes allows an investor to buy one ETF and get a diversified portfolio.
Target Date ETFs
Target Date or Life Cycle ETFs funds have become very popular funds for companies targeting the retirement plans market. Target date funds are basically balanced asset allocation funds with one added feature – they become more conservative as they near the target date. Target-date Funds will reduce risk by selling stocks and buying bonds as the target date approaches.
Saving for retirement is a primary reason investors buy target-date ETFs. These funds are designed for any savings goal that has a targeted end date and for investors who do not want to actively manage their investments. Investor can buy this ETF for the targeted retirement date and then just sit back until the end date.
Alternative Asset Classes
The core of a diversified portfolio should include fixed income and equity investments. But the use of alternative asset classes provide additional diversification. Alternative investments can be used for hedging or trading positions. There are ETFs which give investors the option to take positions in currencies or commodities. Investors can make use of inverse ETFs if they think that the market will decline.
Currency ETFs tracks currency movements in the foreign exchange market. (Forex) ETFs can be bought for individual currencies such as the Swiss franc, the euro, the Japanese yen or a basket of currencies. Foreign currency ETFs can provide investors a hedge against volatility in the currency markets.
Commodity ETFs provide for more diversification in a portfolio. They can also provide protection against unexpected inflation. Commodity ETFs come in three categories. ETFs that track a commodity like gold, oil or soybeans. ETFs that track a basket of commodities and ETFs that invest in groups of companies that produce commodities.
Commodity ETFs funds can hold the actual commodity or purchase future contracts. Un-invested cash may be used to purchase government bonds. The interest returns on bond ETFs are used to cover expenses of the ETF fund and to pay dividends to the share holders.
Inverse ETFs and Leveraged Inverse ETFs
Investors can bet against the market. Inverse ETFs are designed to short the market. These ETFs can utilize the use of short positions of the underlying stocks or futures. ETFs that deal in futures contracts can also purchase bonds with their un-invested cash using the proceeds to cover expenses of the ETF and pay dividends to the owners.
The main reasons to use inverse ETFs is to make a bearish bet on the market or to use as a hedge.
Many investors prefer to use inverse ETFs than selling short the index. Inverse ETFs can be purchased in tax-deferred accounts such as retirement accounts. Which does not allow investors to short stocks because of the risk of unlimited losses.
Investing in ETFs gives investors many options to implement various investment strategies. Strategies can be as simple as diversifying one’s portfolio to more sophisticated hedging techniques.
Core Investment Holdings
Investor should consider utilizing ETFs as core investments in their portfolio. A diversified portfolio can easily be built at a very low-cost by purchasing ETFs to cover major equity asset classes and the fixed-income market. Investor can then customize their portfolio with additional securities, mutual funds or other ETFs.
Building a portfolio for any asset allocation mix can be conveniently assembled through investing in ETFs. This strategy is simple. Investor can even buy ETFs that are already diversified in sectors and asset classes.
Investor can take a passive or active approaches to asset allocation. Rebalancing their portfolio to ensure it stays in line with long-term or strategic objectives. Overweighting those asset classes that are expected to outperform in the shorter term while underweighting other sector expected to decline.
Investors should manage their cash positions to be ready to take advantage of buying opportunities as they present themselves.
ETFs funds can be used to mobilize cash giving investors the opportunity to park money until an opportune long-term investment decision can be made.
Investing in ETFs allows investors exposure to specific sectors, styles or asset classes without having the prerequisite expertise in these areas. Investor with no experience in specific sectors can still invest and diversify their portfolio.
ETFs are available for investors to keep their assets invested rather than laying dormant.
When the first exchange traded funds (ETFs) appeared they were designed to track broad market stock indexes. Today ETFs have been developed to track industrial sectors, investment styles, fixed income, global investments, commodities and currencies. ETFs are now available to replicate just about any index available and with a wide variety of funds to choose from.
The iShares Short-term High Yield ETF SHYG +0.04% is a good choice heading into 2014. With regard to stocks, I expect companies with above-category-average revenue growth to be amongst the best performers.
Heading into 2014, favors the food and beverage sector — well represented in the Power Shares Food & Beverage sector ETF PBJ -0.66% , consumer-discretionary companies represented by SPDR International Consumer Discretionary ETF IPD -1.36% , large-cap multinational pharmaceutical companies represented by SPDR International Pharmaceutical ETF IRY -0.19% and the transportation sector best represented by the iShares Transportation ETF IYT +0.26% . Some of our favorite stocks in our Revenue Buster Portfolio include: Bed Bath & Beyond BBBY +0.03% , Sysco Corp. SYY -0.06% and Visa V +0.17%
Read more >>
ETFs Designed to Profit From a Rising Interest Rate Environment
Eric Balchunas reports on ETFs that will protect you against rising interest rates. He speaks to Adam Johnson on Bloomberg Television’s “Street Smart.”
Focus on Funds: Active Managers Running Scared
Brendan Conway on the ways fund companies are scrambling to counter the threat from index funds, and how it affects investors.