Should I Invest in Exchange Traded Funds? – Long Term Investments Part IV

ETF is a hybrid between Stocks and Mutual Funds.

Exchange Traded Funds (or ETFs) have been available in the US since 1993 and in Europe from 1999. The idea of ETFs is to put funds and stock exchange trading into one product. Traditionally, funds or cash and stock exchange investments have been carefully kept apart to reflect liquidity issues.

An ETF is a pool fund invested with a stated investment objective. Exchange-Traded Funds, or ETFs, are index funds that trade just like stocks on major stock exchanges. ETFs are the most practical vehicle. They help the investor focus on what is most important choice of asset classes. Buy them as you would any stock, at any brokerage firm, Ofcourse you pay brokerage like any other purchase of shares as they are technically shares.

ETF’s as explained by U.S. Securities and Exchange Commission, are : “Exchange-traded funds, or ETFs, are investment companies that are legally classified as open-end companies or Unit Investment Trusts (UITs), but that differ from traditional open-end companies and UITs in the following respects:

* ETFs do not sell individual shares directly to investors and only issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as “Creation Units.”

* Investors generally do not purchase Creation Units with cash. Instead, they buy Creation Units with a basket of securities that generally mirrors the ETF’s portfolio. Those who purchase Creation Units are frequently institutions.

* After purchasing a Creation Unit, an investor often splits it up and sells the individual shares on a secondary market. This permits other investors to purchase individual shares (instead of Creation Units).

* Investors who want to sell their ETF shares have two options:

(1) they can sell individual shares to other investors on the secondary market, or
(2) they can sell the Creation Units back to the ETF.

In addition, ETFs generally redeem Creation Units by giving investors the securities that comprise of the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be-and may not call themselves-mutual funds.”

Types of ETF’s

There are 100′s of different ETF’s to choose from and below mentioned are just a few for reference purpose only :

Standard & Poor’s 500 Index Depository Receipts (SPY:AMEX)
The one of the first and biggest ETF, they are inexpensive funds and pronounced Spiders which tracks the S & P 500 index.

iShares Russell 2000 (IWM:AMEX)
Tracks the Russell 2000 index, a popular benchmark for mid and small-cap companies. This represent 8 to 9 percent of the market.

iShares S & P 500 (IVV:AMEX)
Barclays’ slightly less expensive version of the SPDR tracks the S&P 500 index, iShares is spread out globally and also very popular in Canada, as they offer various combination of ETS industry wise like Gold, finance, Energy etc.

DIAMONDS Trust (DIA:AMEX)
This popular ETF Tracks the Dow Jones Industrial Average, composed of 30 blue chip stocks by wall street.

Nasdaq-100 Index Tracking Stock (QQQ:AMEX)
This ETF Tracks the Nasdaq-100 index, which includes 100 of the largest companies listed on The Nasdaq Stock Market based on market capitalization. Its like buying an Index. There are many more ETF options available all over the globe.

Let us understand difference between ETF over Mutual Fund.

Buying and Selling :

ETFs are bought and sold like shares in any recognized stock exchange where that particular ETF is listed. Essentially, with ETFs, you enjoy both the flexibility of a stock and the diversification of an index fund. ETFs can also be bought on margin and can be sold short. Unlike regular stocks, the price of the ETF changes in real time throughout the day, while most mutual funds are priced at their net asset value (NAV) at 4:00 p.m. daily.

In our view, trading activities completed within the same day are not really transparent.

Liquidity

As we have explained in our earlier part that mutual fund usually keeps ideal liquidity to keep the flow of funds, whereas ETF is invested 100% and therefore ETF has the chance to perform better than Mutual fund.

Trading Strategy

ETF investors can employ trading methods not available to mutual fund investors. These methods, the same as those available to stock investors, aim to provide greater control over the pricing and timing of ETF transactions. For example, technical indicator, trading charts, stop loss, limit order etc.

Expense Ratio and Fees

Average annual expense ratio for ETF is approx 0.46% but carries an additional expenses of brokerage while buying and selling the ETF While Mutual Fund is approximately 0.97% and above., but has fees any where between 0.5 % to 2.7 % annually. This could prove to be very expensive for long term investment.

Services

Services to investor for ETF’s are provided by broker, where as Mutual fund services are provided by Fund sponsored or broker.

Investment Required

There is no minimum investment for mutual fund or ETF, but due to commission involved in buying or selling ETF’s in small amount is not economical, where as mutual fund investment in small amount is economical.

Tax Efficiency

ETFs can be extremely tax-efficient investments when you follow a buy-and-hold strategy. Mostly all ETFs take advantage of the low-turnover indexing approach, so they typically should pass on a small amount of capital gains to shareholders. However, certain types of ETFs, such as those that invest in all-capitalization stocks or in specific market sectors, may experience higher turnover and may possibly be less tax efficient than broader-market ETFs.

Reference Points to find out whether ETFs are right for you Or Mutual fund?

ETFs may be an investment option for:

* Long-term, buy-and-hold investors as buying and holding investors don’t incur frequent-trading costs, as they can reap the benefit of the lower expense ratios.

* Investors with a sizable sum to invest as single large investment spreads the trading commissions across the entire investment, reducing the impact of the fees. In the long term, the lower expense ratios of ETFs can make up for the initial transaction cost.

* Investors looking for the trading flexibility of stocks. As they can be bought or sold like stocks.

A traditional mutual fund is probably a more suitable investment choice for:

* Investors who readjust their portfolio frequently. In that case mutual fund would be a cheap option.

* Investors saving for long term by regular transactions. Or practice dollar cost averaging mutual fund would be economical for them.

* Investors with a small amount to invest have to choose mutual fund for cost effectiveness.

Conclusion:

Mutual fund is good for investor who is in a process saving for long term.

ETF, although it needs reasonable amount to make it worth while, in long run, may have an edge over mutual fund.

TRANSPARENCY: Mutual fund statement is as on a particular day and the activities during the period.

* SINCE THERE IS NO CASHFLOW STATEMENT WE NEVER KNOW THE TRUE PICTURE OF INVESTMENT PATTERN.

* MUTUAL FUND USUALLY SHOWS MAJOR INVESTMENT OF THAT PARTICULAR FUND, BUT DOES NOT EXPLAIN WHERE IS THE OTHER MISCELLANEOUS INVESTMENT INVESTED.

* TRADING ACTIVITY DURING THE TIME IN BETWEEN THE STATEMENT IS NOT REFLECTED AS THEY ARE SUPPOSED TO INCLUDE IN DAILY NAV.

* LIQUIDITY IN HAND IS ALWAYS UNPRODUCTIVE AND MAKES RETURN ON INVESTMENT RELATIVELY LOW.

* 80% OF MUTUAL FUNDS PERFORMANCE ARE BELOW THE MARKET PERFORMANCE.

* MUTUAL FUND CHANGES ITS NAME AND RESTRUCTURES QUITE TO OFTEN AND HENCE DIFFICULT TO TRACK HISTORY OF THAT FUND.

*OVERHEADS:

* MUTUAL FUND FEES ARE HIGHER COMPARED TO ETF’S AND OVER HEADS ARE MORE AS THEY HAVE TO INCUR EXPENDITURE LIKE COMMISSION TO MUTUAL FUND SALES AGENTS AND TRAILING FEES ARE HIGH.

* 2.5% ANNUAL FEES COULD BE TRANSLATED AS 25% ON NET PROFIT IF THEY MADE AN OVER ALL PROFIT OF 10% ON THE CAPITAL AND BE CAREFUL THESE FEES ARE IRRESPECTIVE OF THE PERFORMANCE AND COULD EAT UP THE CAPITAL IN A SIGNIFICANT WAY IN THE LONG RUN.

* FLEXIBILITY:

* PROCESS OF SELLING MUTUAL FUND IS NOT SIMPLE, YOU HAVE TO WAIT FOR NAV AND THEN PLACE AN ORDER.

ETF’S ARE NOT THE BEST OPTIONS, BUT MAY PROVE TO BE BETTER INVESTMENT IN THE LONG RUN FOR CERTAIN CLASS OF INVESTORS.

* TRANSPARENCY IS RELATIVELY HIGHER AS 100% OF THE HOLDINGS ARE DISCLOSED AND THERE IS NO TRADING ACTIVITY IN BETWEEN.

* FEES ARE FIXED AND PRICES ARE MARKET DRIVEN, WHICH MAKES IT A REASONABLE FAIR DEAL FOR LONG TERM INVESTORS. BUYING AND SELLING IS ONE TIME EXPENDITURE, WHICH IS NOT BIG IF THE INVESTMENT AMOUNT IS REASONABLE. BUT COULD BE SUBSTANTIAL IF INVESTMENT AMOUNT IS LOW AND BUYING AND SELLING IS FREQUENT.

* OVERHEADS ARE LESS THAN THAT OF THE MUTUAL FUNDS AS THERE IS NO ANNUAL FEES AND TRAILING FEES TO THEIR AGENTS TO MAINTAIN CUSTOMERS.

* LIQUIDITY IS RELATIVELY HIGH AS ETF’S ARE TRADED ON STOCKS AND PRICES ARE DETERMINED BY THE MARKET.

We do not recommend mutual funds or ETF’S as investment by individual or investor. Investment decision made by the investors must be through their registered advisors, as every investor has different risk tolerance, objectives and time frame.

This article is written with the best knowledge of the author and neither the author nor ForexMetrics Inc. is responsible for any decision made based on this article. This article is for reference and knowledge purpose only and shall not be treated as an advice. Consult your registered broker or advisor before investing.

By Kersi Jilla - ForexMetrics

Disclaimer
Please be advised that above views are of the author of ForexMetrics and above material is for the purpose of reference only and author or Forex Metrics Inc. will not be responsible for any decision based on the above material. We recommend that you consult your financial registered or license advisor before making decisions. Read our Legal Disclaimer and Terms Of Use.

Should I Invest in Exchange Traded Funds? – Long Term Investments Part IV

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