Q & A for exchange-traded funds | VailDaily.com

Q & A for exchange-traded funds

Richard Loth

Exchange-traded funds, commonly referred to as ETFs, are a relatively new investment vehicle. Lately, 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 remarks will explain this new investment phenomenon in terms that are understandable to the general investing public.What are they? ETFs are passively managed portfolios of securities that track a variety of indexes. They are exchanged-listed, principally on the American Stock Exchange, and, therefore, trade just like conventional stocks. As such, while similar to index mutual funds, they are not mutual funds. ETFs are “baskets” of individual securities – stocks and/or bonds – that have all the characteristics of stock. It’s worthwhile noting that the Wall Street Journal’s table listing ETFs is captioned “Exchange-Traded Portfolios.”Examples of popular exchange-traded funds would include SPDR Trust:1 (SPY), or “spiders;” Nasdaq-100:1 (QQQ), or “cubes;” and Diamonds (DIA), which, respectively, reflect the composition of the S&P 500 Index, the NASDAQ 100 Index, and the Dow Jones Industrial Average, respectively.Principal characteristicsETFs, because they are stocks, are bought and sold through a brokerage account, which means that broker commissions apply. There are a wide variety of stock and bond ETFs covering the broad market, market sectors and specialty industries. The operating expense ratios of ETFs are often, but not always, lower than corresponding 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?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 those limitations. An ETF investor is generally an active trader who enjoys what’s called “trading flexibility.” The individual investorThe question is are ETFs 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 activity. 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.The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing, an independent registered investment adviser. Loth can be reached at (970) 827-5591 or mentorinvesting@comcast.net.Vail Colrado

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