Q & A for exchange-traded funds
Investing WiselyRichard Loth Exchange-traded funds, commonly referred to as ETFs, are a relatively new investment vehicle. Over the past year, ETFs have gotten a lot of exposure in the financial press, and it’s certainly fashionable in investment circles today to consider including ETFs in one’s portfolio. Hopefully, the following questions and answers will give readers a basic understanding of ETF investing:• What are exchange-traded funds? Exchange-traded funds are passively managed portfolios that track a variety of indexes. It’s worthwhile noting that the Wall Street Journal’s table listing ETFs is captioned “Exchange-Traded Portfolios.” While similar to index mutual funds, they are different. ETFs are exchanged-listed and, therefore, have all the characteristics of stock and trade just like conventional stocks. Examples of popular exchange-traded funds would include SPDR Trust (SPY), or “spiders,” Nasdaq-100 (QQQ), or “cubes,” and Diamonds (DIA). These ETFs reflect the composition of the S&P 500 Index, the NASDAQ 100 Index, and the 30-stock Dow Jones Industrial Average, respectively.• What are the principal characteristics of ETFs? Because they’re stocks, ETFs are bought and sold through a brokerage account, which means that broker commissions apply. There is an increasing variety of stock and bond ETFs covering the broad market, certain market sectors, and specialty industries. The operating expense ratios of ETFs are often, but not always, lower than corresponding index mutual funds. There are some market-pricing and tracking-error issues with ETFs, but most observers agree that any resulting valuation discrepancies for most exchange-traded funds are insignificant.• What’s the difference between ETFs and index funds? Mutual funds, which include the index variety, have a number of trading limitations when compared to stocks. They are only priced at net asset value (NAV) once a day after the trading day closes; they cannot be bought on margin (borrowing money from a broker); they are sold by and redeemed from the fund company; and they cannot be shorted (borrowing shares you don’t own from a broker).Since an exchange-traded fund is a stock, it does not have these limitations. An ETF investor is generally an active, professional trader who enjoys what’s called “trading flexibility.” • Are ETFs an appropriate investment for individual investors? Yes and no. Exchange-traded funds were created in the 1990s in response to professional and institutional investors’ desires for sophisticated, active trading of broad-based mutual funds, which they couldn’t do. For 99.9 percent of individual investors, i.e. most of you reading this column, day-trading, using margin accounts, shorting stocks, etc. should never even be considered as part of your investing activities. In addition, for those individual investors in the nest egg accumulation phase, e.g. 401(k) plan participants and others saving for retirement, the brokerage transaction costs of making, let’s say, monthly ETF investments of modest dollar value, would be prohibitive. ETFs are most appropriate for one-time, large purchases as part of a buy-and-hold investing strategy.Where ETFs make sense for individual investors is in those cases where a substantial sum of money becomes available through an inheritance, an insurance payoff, a big commission payment, or reallocating material dollar amounts in an existing investment portfolio. Rather than having to consider a large number of individual stock or fund selections, an ETF is a convenient “wholesale” approach to achieving broad-based asset allocation and diversification objectives.• Where can you get more information on ETFs? I would recommend logging onto About’s Web site, http://www.mutualfunds.about.com, and, under the Articles and Resources tab, click on ETFs. Another good source is Yahoo!’s finance page, finance.yahoo.com, where you can click on ETF under the Investing tab. Also, during the past year, a lot has been written about exchange traded funds in the financial press. A perusal of any of the mainstream personal finance magazines will turn up an abundance of informative articles. The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing, an independent registered investment adviser. Loth can be reached by emailing email@example.com or calling 328-5591.Vail, Colorado
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