Exchange Traded Funds or “ETFs” were first introduced in the early 1990s, but it wasn’t until 2008 that the first actively managed ETF reached the market. In less than 10 years this section of the market has grown to over one trillion in assets.
Covering Exchange Traded Funds in one article will be similar to returning from Sanford Stadium in one hour on game day. Translation: Very hard. Today, let’s touch on the basics along with the positives and negatives.
By definition, ETF is a marketable security that tracks an index, commodity, bonds, or assets like index mutual funds. ETFs will typically have lower fees than mutual funds which can make them attractive to individual investors.
As is the case with all securities there are advantages, disadvantages, and special risks you need to be aware of if you are considering an investment in ETFs.
ADVANTAGES:
Diversification
One ETF can concentrate on a group of equities, market segments or styles.
Lower Fees
ETFs have lower expense ratios than other managed funds. Mutual fund expenses include such costs as a sales charge, management and marketing fees.
Trades like a stock
ETFs trade at a price updated throughout the day instead of being priced at the end of the day.
Capital Gains Tax Exposure on ETF Capital
Most of the tax on ETF capital gains is paid on sale while mutual funds are required to distribute capital gains to shareholders if securities are sold at a profit.
DISADVANTAGES:
Dividend Yields
ETF dividend yields may not be as high as owning a high yielding stock or group of stocks.
Costs could be higher
If you compare an ETF with a stock, you may pay more as there is no management fee for a stock.
Liquidity
If an ETF is thinly traded, there could be problems in cashing out. The biggest sign of an illiquid investment is a large spread between the bid and ask price.
Dollar Cost Averaging
Many investors prefer incremental investing, but ETFs are better suited to be purchased in a lump sum to avoid paying a broker commission on each and every purchase.
There are risks in Exchange Traded Funds you should be aware of. The greatest risk is of course the market risk.
Envision ETFs as a wrapper for the investment (my favorite is Snickers). So when that particular investment drops, the value of your ETF will drop also. A good example is the market drop in 2008.
There is a special risk found in an ETF called Inverse ETFs. An Inverse ETF attempts to deliver returns opposite of the index returns. If an index goes down 2%, the ETF should go up 2% and vice versa. These funds can do well if the market is going in only one direction.
A Leveraged ETF is designed to generate a multiple gain on the index it is tracking on a daily basis. The potential problem here is that an increase followed by an equal correction the next day could double or triple your loss.
An ETF that is both Inverse and Leveraged has some substantial exposure if you hold the asset for more than one day. These two techniques are best suited for investors willing to monitor their portfolios on a daily basis.
Exchange Traded Funds without question offer some attractive alternatives to mutual funds in terms of reduced expenses, tax advantages and liquidity.
In my opinion, ETFs should prove attractive to individual investors who do not want to use an advisor. They are also useful to an investor who wants to utilize an independent money manager who is not employed by a firm promoting traditional mutual funds.
Sources: Investopedia; “Brief History”, “Advantages and Disadvantages”, and “Five ETF Flaws”
Mike Lassiter is a Chartered Life Underwriter and Chartered Financial Consultant. He is a Licensed Insurance Counselor and a Registered Investment Advisor. He can be reached locally at 770-786-2781.
