Exchange-Traded Funds
ETFs are investments that track a particular index, a broad sector, or a group of international stocks through a basket of securities. Although they are constructed like mutual funds, ETFs trade like individual securities on stock exchanges. This gives investors the best of both worlds, as they combine the conservative diversity of a mutual fund with the flexibility of a stock. Almost anything that can be done with a stock can be done with an ETF.
Types of ETFs
Before investing in ETFs, it is useful to understand that ETFs are created by different financial institutions, each of which uses slightly different structures. For the most part, they are the same, with the notable exception that HOLDRS are only traded in 100-share increments. Most other ETFs - iShares, SPDRs, and popular broad-market ETFs such as the Nasdaq-100 Trust (QQQ) - trade in one-share increments. Below is a description of some of the ETFs you will most likely encounter.
iShares
iShares trade like traditional stocks and are available in increments as small as one share. They can be traded at any time during normal market hours and use all the portfolio-management approaches associated with stocks (e.g., market orders, limit orders, stop orders, short sales, and margin buying). Each iShares fund owns a pool of securities designed to closely track the performance of any one of an array of market sectors. There are more than 100 different iShares available which give investors the ability to gain exposure to most major market indices as well as numerous sectors. Additionally, many iShares are now optionable, which extends the usefulness for both investing and hedging.
HOLDRS
HOLDRS are a special breed of ETFs because they enable an investor to hold a basket of stocks in a particular industry, sector, or group. Examples of such sectors include biotechnology, retail, oil services, pharmaceutical, and semiconductor, among many others. Unlike other ETFs, which can be purchased in blocks as small as one share, HOLDRS can only be acquired and sold in 100-share increments. HOLDRS can also be bought and sold through their parent company, Merrill Lynch, while all other ETFs need to be traded through a brokerage house.
SPDRs
There are currently (as of 8/04) nine Select Sector SPDR Funds, all of which seek to replicate the price performance of their corresponding Select Sector Index, although, as with all trading instruments, the funds offer no price guarantee. When combined, the nine Select Sector Indexes contain all 500 components of the S&P 500 Index. The sectors represented in the Select Sector SPDR Funds are: Consumer Direct (XLY), Consumer Staples (XLP), Energy (XLE), Financial (XLF), Health Care (XLV), Industrial (XLI), Materials (XLB), Technology (XLK), and Utilities (XLU).
Others
There are additional ETFs available to investors, but these are traded on a more infrequent basis and are not yet quite as popular as the funds mentioned above. Among these are VIPERs, a Vanguard family of funds. The family of VIPERs is rather large, offering a number of sector-based funds such as the Vanguard Consumer Staples VIPERs (VDC), the Vanguard Health Care VIPERs (VHT), and the Vanguard Financials VIPERs (VFH). There have also been several broad-based VIPERs issued to mimic the performance of the SPX, the Russell 2000 Index, and other major market averages.
Another ETF worthy of mention is the Fortune 500 Index Tracking Stock (FFF), a broad-based fund issued by State Street designed to correspond to the Fortune 500 Index. State Street also offers a family of streetTRACKS ETFs, most of which are broad-based in nature and designed to correspond to various Dow Jones averages.
Examples of Major Market Indices That Are Frequently Discussed
- S&P Depositary Receipts (SPY, or “spiders”). SPY represents ownership in a unit investment trust established to accumulate and hold a portfolio of the equity securities that comprise the S&P 500 Index (SPX).
- Nasdaq-100 Trust (QQQ, or “cubes”). QQQ is technically known as the Nasdaq-100 Index Tracking Stock and represents ownership in the Nasdaq-100 Trust, a unit investment trust established to accumulate and hold a portfolio of the equity securities that comprise the Nasdaq-100 Index (NDX).
- DIAMONDS Trust (DIA). DIAMONDS represent ownership in a unit investment trust established to accumulate and hold a portfolio of the equity securities that comprise the Dow Jones Industrial Average (DJIA).
- S&P MidCap Depositary Receipts (MDY). MDY represents ownership in a unit investment trust established to accumulate and hold a portfolio of the equity securities that comprise the S&P MidCap 400 Index.
- iShares Russell 2000 Index (IWM). IWM tracks the Russell 2000 Index (RUT), which is comprised of mid-cap and small-cap companies with market values ranging from $20 million to $300 million.
ETF Advantages
1. Investing Flexibility
Because ETFs trade on an exchange, they can be:
- Bought and sold at any time during the trading day (at intraday market prices)
- Purchased on margin
- Sold short, even on a downtick. As such, ETFs can be used as a viable hedging strategy against one’s core stock portfolio.
- Traded using stop orders and limit orders
2. Diversification
The basket-of-stocks philosophy utilized in ETF trading provides diversity that it as deep and wide as an index or sector itself. What’s more, the ETF market itself is growing rapidly to provide more and more choices.
3. Tax Advantages
The method in which ETFs are created and distributed means that an investor does not need to dole out capital-gains taxes until he completes the final sale of the ETF in his portfolio. As far as the Internal Revenue Service is concerned, ETF trading is considered to be in kind, as identical items are exchanged for one another (an ETF for the basket of stocks of which the ETF is comprised). Mutual funds, however, involve the transfer of currency, which effectively signals the tangible realization of capital gains. It may be a technicality, but it’s one that works to the advantage of ETF investors.
The delay in paying taxes derived from trading ETFs rather than mutual funds can be beneficial for a stock portfolio. After all, the longer money is held onto rather than paid toward taxes, the more money it can accrue via interest payments and additional return on investment.
4. Cost Advantages
ETFs are not actively managed and are therefore less expensive to trade than mutual funds. Data from Morningstar indicates that the average sector mutual fund bears an average expense ratio (operating costs including management fees but not including commissions, measured as a percentage of the fund’s assets) of 1.72 percent. The average ETF holds an expense ratio of 0.47 percent.
*Does not include HOLDRS, which charge $2 per quarter for each 100-share lot
Data Source: Morgan Stanley
ETF Risks
As with any investing vehicle, there are risks. Below are some of the potential risks to be aware of when trading ETFs.
1. Market Fluctuations
- The stocks tracked within an ETF are subject to the same risks as traditional equities. If the component stocks decline due to weakening fundamentals, crumbling technical support, global events, or any other market fluctuations, the value of the ETF will go down.
- Fixed-income-based ETFs are subject to the same risks endured by bond traders, such as the interest-rate environment.
- International ETFs run the risk of capital loss due to currency fluctuations or instability (economic or otherwise) in the nations followed by the ETF.
2. Credit Risk
If an ETF issuer is unable to make payments of principal and interest when due (such as on a corporate bond), the fund’s inherent value and ability to pay dividends may be compromised.
Popularity: ETFs Are the Wave of the Future
The idea of an ETF entered the investing lexicon in January 1993, when Standard & Poor’s Depositary Receipts (SPY), or Spiders, was introduced to track the movement of the S&P 500 Index (SPX). That year, $461 million changed hands on the ETF. In early 2004, the American Stock Exchange (AMEX) reported that the ETF market was worth $167 billion. While total ETF assets are still a mere fraction of the $7.6 trillion in assets devoted to mutual funds, the popularity of ETFs is definitely on the upswing.
Data Source: The American Stock Exchange
Conclusion
ETFs are a hybrid product that gives investors the benefits of mutual funds along with the flexibility of stocks. This area of the financial markets has seen rapid growth as more and more understand the advantages ETFs offer. Long-term investors and short-term traders alike have found these securities useful. As the popularity of ETFs has grown, so has the liquidity in the market for different options on them, which only adds to ways that you can use them.
