Just as Dorothy and her friends were singing about Lions, Tigers and Bears as they skipped down the yellow brick road on their way to see the Wizard of Oz, many investors are skipping down the investment road singing the praises of Exchange Traded Funds (ETFs).  

At the most basic level, ETFs are close cousins to mutual funds because they are made up of individual securities.  The major differences are that ETFs trade like stocks, meaning they can be bought and sold throughout the trading day. They can also be sold short and bought on margin--in brief, anything you might do with a stock, you can do with an ETF.  Unlike the majority of mutual funds however, ETFs are not actively managed.  They just represent a basket of securities, and no one is really paying attention to the performance of those underlying stocks.  Since there is little or no management most also charge lower annual expenses than even the least costly index mutual funds.

There are many different kinds of ETFs on the market currently and their number is growing.  If there is an established index out there you can buy it with an ETF.  Spiders (SPDRs) represent the S&P500 index, but there are also sector SPDRs.  These can be purchased if you are looking for a particular sector of the market to add to your portfolio. 

Diamonds (Diamond Trust Series) represent the 30 stocks that make up the popular Dow Jones Industrial Average.  Rather than buy all 30 of the stocks, you can pick them up by buying shares of Diamonds.  

The NASDQ also has an ETF you can buy if you want a low cost alternative to purchasing this index.  Just ask your broker to buy you some Cubes (QQQ) and you will own a representative sample of that popular index.  

How Do ETFs Work?

As mentioned previously ETFs represent a basket of securities.  Unlike mutual funds though, you do not buy them from the originating company.  ETFs are purchased on the open market from investors looking to sell their shares.   Furthermore they don’t always trade at the actual value of the underlying securities.  Forces of supply and demand for the ETF shares, as well as the underlying values of the securities determine the market price of an ETF.  The explanation for the reasons behind these price variations could fill several pages.  Just be on guard, the potential does exist for ETFs to trade at prices above or below the value of their underlying portfolios. 

Are ETFs Right for You?

ETFs have several clear advantages over traditional mutual funds. Most notably, their annual expense ratios are considerably lower. They're also more tax-efficient, and they can be traded throughout the day. Nevertheless, they aren't suitable for everyone. Just like any other investment you have to understand what it is you are putting your hard-earned dollars into.

Trading Flexibility

One key advantage that ETFs have over traditional mutual funds is trading flexibility. ETFs trade throughout the day, so you can buy and sell them when you want. However as previously mentioned they may be sold at a premium or discount, especially with the more thinly traded funds.  Heavily traded issues such as SPDRs and QQQs should trade right around the value of their underlying securities, but premiums and discounts can arise. Moreover, it is not yet known how ETFs might behave in the face of a full-fledged market correction. It's conceivable that investors wishing to sell in the midst of such an event would have to part with their shares at prices below their net asset values. 

Costs 

ETFs are known for their low operating expenses.  For example the SPDR has an operating expense of around 0.12% while mutual funds tracking that index may be up around 0.5%.  Operating costs are only part of the picture.  Since they act like stocks, you get to pay a commission to buy and sell ETF shares.  If you plan on trading them actively like a stock you may find yourself racking up some hefty trading costs.  Plus it defeats the purpose of owning a passively managed index if you plan on actively trading it.  
 
If you like the idea of owning ETFs as part of your portfolio you may want to consider only buying them in large amounts.  Using dollar-cost-averaging for example with ETFs gets pretty expensive, even at a low commission of $8 per trade.
 
Taxes

With a regular mutual fund, you don’t have much control over the tax consequences of the fund.  The investment manager may be selling to meet redemption orders or take profits, which may not be in keeping with your investment strategies.  You can mitigate this somewhat by carefully choosing your funds with an eye on taxes, but the bottom line is you are at the mercy of the fund manager.  With ETFs you don’t incur a taxable event until you actually sell the shares.  Furthermore you can be sensitive to the timing of the sale and keep most of your redemptions in the long-term capital gain category.  

All of this should make ETFs more tax-efficient than most mutual funds, and they may therefore hold a special attraction for investors in taxable accounts. Keep in mind, however, that ETFs can and do make capital-gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying benchmarks. 

Conclusion

ETFs have a lot to offer. They're flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading, making them more tax-efficient than most mutual funds. Nevertheless, be careful when considering ETFs.  

If you are firmly in the passive management camp of investing, ETFs are perfect for you.  You can build a well-diversified investment portfolio by incorporating multiple ETFs to cover the various investment styles and do the periodic rebalancing. 

If more active management is your cup of tea, consider some of the sector ETFs to cover those bases.  Sectors and investment styles do rotate and ETFs can be an effective tool in taking advantage of those shifts.  Just be sure you keep an eye on their operating expenses and are sensitive to the trading costs you may be racking up.  

These are just a few of the ways that ETFs can be used to build your long-term wealth.   Knowing how they work and the best ways to utilize them may increase your chances of skipping happily down the road to retirement. 
 
 

Contact Mark Neil at:
Northwest Wealth Advisors, Inc 
0605 SW Taylors Ferry Road
Portland, OR 97219
Office: (503) 478-6632 
Fax: (503) 595-1863 
Email: mneil@nwwealtadvisors.com 

© 2003 Mark Neil