Wealth Building Lessons

We’ve been brain-washed into believing that mutual funds are the only low-risk investment alternatives to stocks and real-estate besides government bonds or direct checking/saving accounts with a financial institution. This is no longer true and Exchange-traded funds (ETFs) is one prime example.

ETFs can best be described as a blend between index mutual funds and market-based securities and are legally classified as open-end companies or Unit Investment Trusts (UITs). ETFs are similar to index funds in that they will primarily invest in the securities of companies that are included in a selected market index (either all securities ore representative sample). ETFs can also track the price of commodities like gold (GLD) and crude oil (USO). EFTs are bought and sold like stocks on major exchanges but differ from traditional open-end companies and UITs in a number of ways:

1. ETFs do not sell individual shares directly to investors. Instead, they issue their shares in large blocks known as “Creation Units” to institutional investors. The size of the blocks can vary tremendously but it’s not unusual to see blocks of 50,000.

2. Institutional investors typically do not purchase Creation Units with cash but rather with a basket of securities that generally mirrors the ETF’s portfolio.

3. After purchasing a Creation Unit, an institutional 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).

4. Institutional 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 institutional investors the securities that comprise 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.

The advantage of using this method for the ETF fund manager is that the institutional investors cover the dealing costs in purchasing the required shares to make up the portfolio. They are willing to do this so they can profit from arbitragebased on the trading price of shares on the secondary market. This provides cost efficiency for the ETF managers as the bulk buying power of the institutional investors allows them to avoid the expense of mass share creation and deletion.

Now why would you buy an exchange-traded fund instead of an individual stock. The answer lies in less volatility and increased diversification. Individual stock prices can vary tremendously as we’ve seen in the last decade. Investments vehicles such as mutual funds will help you diversity to lower the risk but you are still exposed to the sector risk. With ETFs you can buy and sell baskets of securities either in one industry or sector, with the convenience of a stock.

Additional advantages with ETFs include:

1. Liquidity

ETFs can be bought and sold anytime during a market trading day. This enables investors and institutions to hedge their positions. Mutual Funds are typically bought and sold at the end of the trading day and due to new SEC regulations, if you cannot sell them within a certain time period. A more subtle advantage is that ETFs, like closed-ended funds, are immune from some market timing problems that have plagued open-ended mutual funds. In these timing attacks, large investors trade in and out of an open ended fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term unit holders. With an ETF (or closed-ended fund) such an operation is not possible–the underlying assets of the fund are not affected by its trading on the market.

2. Low Expenses

ETF expense ratios are very low (0.40% on average) compared to index funds (0.65% on average). Some mutual funds can have expenses up to 3%. Over the long term, these differences can compound significantly.

3. Better Performance

In the long run, indexed investments, such as ETFs, perform better than most actively managed mutual funds.

4. Tax Benefits

ETFs allow an investor to pay most of his capital gains upon final sale of the ETF. In mutual funds, when shares are sold for a gain, the gain is distributed and all shareholders experience a taxable event.

Before purchasing ETF shares, you should carefully read all of an ETF’s available information, including its prospectus.

Related Books
1. Investing with Exchange-Traded Funds Made Easy: Higher Returns with Lower Costs

2.ETF Trading Strategies Revealed

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