An ETF, or exchange traded fund, is an excellent alternative to a mutual fund and is more appropriate for those who enjoy the intricacies of trading.
What is an ETF?
First off, what exactly is an Exchange Traded Fund (or “ETF”)? It may seem like it should just be another type of mutual fund that trades on the stock market like any other investment company. But there are some differences between ETFs and regular mutual funds — mainly tax efficiency.
Mutual funds operate as separate legal entities from their shareholders, meaning that all profits go directly into paying out dividends each year instead of being taxed at the individual investor level.
As such, most people don’t pay taxes when investing through mutual funds; however, with an ETF, everything goes straight back into buying shares, so every share owner pays taxes based on his or her marginal income-tax rate. In fact, only about 20% of ordinary mutual fund money ends up going toward shareholder distributions.
The rest gets thrown away on fees paid to managers. With an ETF, this problem doesn’t exist because the returns stay within the organization itself. This means that these expenses get passed onto the buyer instead of having to be absorbed by shareholders themselves. Another major difference is trading volume.
Since many mutual fund companies trade less frequently than once per day, the price movements of those stocks tend not to reflect current supply and demand for the particular securities that make up the fund. An ETF offers greater liquidity since its prices move much faster due to the nature of its transactions.
Finally, there is also no need to worry if someone else owns too large a stake in your mutual fund. There aren’t usually limits placed on who buys shares of a specific mutual fund, but with an ETF, everyone has equal access to the same product regardless of size.
So now we know why an EFT exists, but what kinds of products does it specialize in? First things first, let’s talk about indexing. Index funds were originally created to provide passive management of an entire market sector without requiring constant attention from active traders. They’re basically the opposite of actively managed funds which attempt to pick winning stocks, bonds and commodities without relying on objective criteria.
One example would be picking a high growth technology startup over a stable blue chip like Microsoft. By focusing solely on indexing, the manager isn’t forced to act quickly against changing conditions and potential risks associated with new developments. Because of this, indexers often end up outperforming active managers after inflation adjustments.
For instance, according to Vanguard research, during 2001 – 2005, American equity index funds returned almost twice as much as hedge funds, even including performance before adjusting for inflation. Another popular class of ETFs is called commodity funds.
Basically, they consist of futures contracts tied to various natural resources like oil, gold, silver and platinum. Their main function is to take advantage of rising prices while providing exposure to different parts of the economy. When you think of basic necessities like food and energy, you probably consider staples like bread and gasoline, right?
Well, with a commodity fund like Energy Select Sector SPDR (XLE), you could actually invest in something like corn ethanol, biodiesel or soybean meal! If you want to gain exposure to alternative fuels like biofuels or hydrogen, then look at MLCX Biofuels ETN (FUE) or Global X Hydrogen ETF (HYDR).
On the flip side, you might want to increase your holdings in materials like copper, aluminum or iron ore. Then check out Global X Copper Miners ETF (COPX) or iShares S&P Global Materials ETF (Ticker: SLX), both of which hold stakes in global mining firms.
Or maybe you’d rather stick closer to home and focus on U.S.-based manufacturing businesses like 3M (MMM) or Whirlpool Corporation (WHR). These can both be found in ETFs. You can find plenty of options with the help of Morningstar Investment Research. But remember, there are hundreds of thousands of possible ETF choices available across dozens of categories.
So how do you choose one that fits your needs? Read on…
Types of Exchange Traded Funds
There are several different types of exchange traded funds on today’s markets. Here are a few examples:
- Active vs. Passive Management: Some funds aim to beat the indexes by using advanced quantitative analysis techniques, whereas others simply try to match benchmarks. Generally speaking, passively-managed funds are cheaper and thus less risky than actively-managed ones, but they typically underperform. Active managers generally charge higher fees, but they tend to perform better than similar funds.
- Diversification: Most standard ETFs are designed to track broad indices. However, specialized ETFs allow you to target specific sectors or subgroups, allowing you to build portfolios tailored specifically to your interests.
- Taxes: Taxable Vs. Tax-free ETFs differ greatly depending on where your capital gains fall. Investors should consult a financial advisor prior to making decisions regarding investment strategy.
- Regulation: Government oversight varies from country to country. Check with your state government or local regulatory agency to see whether certain regulations apply to your choice.
In addition to choosing among the vast array of existing ETFs available, you can create your own custom version of the already established models. Say you’ve decided to buy five shares of Apple Inc.’s AAPL stock. Instead of waiting around until tomorrow morning to place your order, you can use online brokerage services like TradeKing to set up an automatic transfer of money from your bank account into the appropriate ETF accounts.
Your transaction won’t show up on your monthly statement, either, further protecting your privacy. When deciding what kind of fund to purchase, keep in mind that different types of funds require differing degrees of risk tolerance. For instance, a conservative person looking for lower volatility in their retirement savings might opt for low-volatility index funds.
A moderate investor seeking medium stability could select balanced/diversified funds. Those interested in higher risk opportunities might venture into foreign currency or emerging market funds. Of course, if you really want to play the odds, you could always roll the dice with leveraged funds or inverse funds.
Finally, if you plan on holding onto your investment for awhile, you’ll undoubtedly want to ensure that the value of your chosen ETF remains stable. You’ll want to compare your returns to benchmarks like the S&P 500 to see if you are beating the market. One ETF that mirrors the peformance of the S&P is SPY.