Exchange Traded Funds (ETFs) are
open-ended investment funds listed and traded intraday on a stock
exchange. They aim to track the performance of an index and provide access
to a wide variety of markets and asset classes. ETFs are not mutual funds,
yet they offer all of the benefits of diversification that you would
expect from a mutual fund.
Quick Facts:
ETFs are the most innovative and rapidly growing
investment vehicles.
Like stocks, ETFs trade on an exchange.
Unlike regular mutual funds, ETFs can be bought and sold throughout the
trading day. They can also be sold short and bought on margin. Anything
you might do with a stock, you can do with an ETF.
There are
a number of different ETFs on the market, including Qubes, SPDRs, sector
SPDRs, MidCap SPDRs, HOLDRs, iShares, and Diamonds.
Most ETFs
are passively managed, which means that each tracks a sector-specific,
country-specific, or broad-market index. A manager isn't actively choosing
which stocks to buy and sell.
There are $705
billion in in 925 ETFs (Dec 2009) versus $12 trillion in mutual funds,
but the momentum is shifting. In fact, seven of the 10 best-selling
funds are ETFs.
Why invest in ETFs?
Exchange-traded funds offer the following
advantages:
Lower investment cost : ETFs have lower expense ratios than
index and mutual funds, generally less than 1%.
Transparency: Investors have access
to the component securities represented in an ETF. Moreover, market
prices are published real-time throughout the trading day.
Flexibility & liquidity: An investor can buy
and sell ETFs anytime during trading hours and may employ the
traditional trading techniques including stop orders, limit orders,
margin purchases, and short sales. In today's markets with increased
volatility, the ability to capture short-term movements can make the
difference between a good day and a bad one.
Diversification: ETFs provide
instant diversification in an industry you might know little about. ETFs give traders a way to make smart plays in a sector, rather than
trying to pick individual stocks and hoping to choose the right ones.
Commodities and currencies: ETFs
allow investing in commodities (such as oil, gold or agricultural
products) and currencies (euro, yen, etc). These products required
access to futures and forex trading before ETFs were created.
Options: ETFs function just like a stock, because they represent a
collection of individual stocks in a single sector. Accordingly, you can
trade calls and puts on them to take advantage of movements in that
particular sector.
What are Exchange-traded notes (ETNs)?
ETNs are structured products that are issued
as debt securities by banks and are based on the performance of various
assets, indexes and strategies. ETNs are not investments funds.
When you buy an ETN, instead of putting your money into a fund that
acutally buys and holds assets, you are buying debt from the ETN issuer —
much like a bond investor would. Instead of being backed by the assets
that are in the investment fund like ETFs are, ETNs are simply backed by
the full faith and credit of the issuer.
ETNs have maturity dates. When you hold an ETN until the maturity date,
you receive a one-time payment based on the performance of the underlying
asset, index or strategy.
For instance, if you buy an ETN covering oil
and the value of oil appreciates during the time you are holding the ETN,
you will receive a higher payment at maturity than you will if the value
of oil depreciates during the time you are holding the ETN.
Of course, you do not have to hold an ETN until maturity if you don't want
to. You can sell your ETN at any time on the open market.
What's wrong with mutual
funds?
Lack of transparency.
High expense ratios and hidden fees.
In a mutual fund, you're trapped because you can't leave the stock
intraday. The NAV of the fund is calculated at the end of the business
day, so you are stuck with that price and the implications of whatever
movements occurred during the session.
What are the risk considerations before investing in ETFs?
Market risk: Since ETFs usually
target one specific sector, investors can focus on one hot sector.
However, this makes them prone to greater risk and market volatility.
Tracking error: An ETF may not be able to exactly replicate the
performance of the underlying index due to management fees, timing
differences and other factors.
Foreign exchange risk: Investors whose base currency is other than
the currency denomination of the ETF will be subject to the risk of
fluctuations in currency values.
Risks Associated with Exchange-Traded
Notes (ETNs)
ETNs, just like any other investment, carry risk. However, ETNs carry the
following two risks that ETFs don't:
1. Credit Risk: Credit risk is the
risk that the institution that has issued the ETNs will default on the
notes.
Remember, ETNs are issued as unsecured debt securities — meaning there
are not specified assets that serve as collateral for the ETNs. Instead,
ETNs are only backed by the full faith and credit of the issuer.
In good times, this isn't typically a problem. But during a financial
crisis when banks and other large financial institutions — the main
issuers of ETNs — are at risk of collapsing, it can be a big problem.
2. Call Risk: Call risk is the risk
that the issuer of the ETN may call the ETNs back before maturity.
If an issuer calls an ETN back, the issuer will compensate you for the
ETN according to the call provision in the ETN, but you will lose the
right to hold the ETN until maturity.
Most popular ETFs, sorted by daily volume:
(*) click on the symbol to view a chart on Yahoo Finance:
