Getting to Know Exchange-Traded Funds
Qubes. StreetTracks. HOLDRs. Names of popular rock groups? Not even close. They're all investments called exchange-traded funds (ETFs) and many people use them to build a diversified portfolio. Maybe you should, too -- if you understand the risk/reward trade-offs.
An ETF is a basket of securities, shares of which are sold on an exchange. They combine features and potential benefits of stocks, mutual funds, or bonds. Like individual stocks, ETF shares are traded throughout the day at prices that change based on supply and demand. Like mutual fund shares, ETF shares represent partial ownership of a portfolio that's assembled by professional managers.
Types of ETFs
There are a number of types of ETFs, each with a different investment focus. Following are some of the most common ETFs.
- Diamonds follow the 30 large-cap companies that make up the Dow Jones Industrial Average.
- Standard & Poor's Depositary Receipts (Spiders) mirror the S&P 500, an index of 500 of the largest companies in the United States. They also track select sectors of the S&P 500.
- iShares hold baskets of stocks in specific regions of the world, select countries, or sectors, or follow U.S. corporate or government bond securities.1
- Qubes track the 100 largest businesses of the technology-driven Nasdaq Composite Index.
- StreetTracks replicate various indexes focused on sectors, countries, or investment style.1
- Holding Company Depositary Receipts (HOLDRs) are ETFs with a twist. They usually focus on narrow, emerging sectors -- companies building the Internet infrastructure, for example -- and their baskets hold only about 20 stocks to begin with. Stocks will never be added, and over time a HOLDR's basket can become even more concentrated, as stocks that are lost due to mergers aren't replaced. HOLDRs also differ from most ETFs in that they only trade in lots of 100 shares and shareholders can exchange their shares for the underlying stocks at any time by paying a fee.
Investors should note that because many HOLDRs are narrowly focused, they can be more volatile than other types of ETFs. Also, HOLDR investors will receive annual reports and other investment-related information for each of the 20 stocks in their HOLDR basket. On the other hand, they'll only pay one brokerage commission instead of 20.
Originally ETFs were organized as unit investment trusts (UITs). In a UIT, an investment company buys a fixed portfolio of securities and then sells shares of that portfolio to investors. This type of structure results in dividends being held in an interest-bearing account, which are deposited into the ETF once each quarter. The delay in investing dividends can have a slightly negative effect on the total return of the ETF because the dividends are held as cash instead of being invested. Spiders, Diamonds, and Qubes are all organized as unit investment trusts.
Other ETFs, such as iShares, Select Sector Spiders, and StreetTracks, are structured as open-end funds. This arrangement follows the typical mutual fund structure in that new shares are continually offered and redeemed by the investment company. An open-end structure allows dividends to be reinvested immediately.
These investments offer a number of potential advantages, including:
Tax efficiency -- ETFs may be more tax efficient than some traditional mutual funds. A mutual fund manager may trade stocks to satisfy investor redemptions or to pursue the fund's objectives. Selling shares may create taxable gains for the fund's shareholders. Because ETFs are like stocks, redemptions aren't an issue. In addition, managers of index-based ETFs only make trades to match changes in their index, which may mean greater tax efficiency.
Low expenses -- ETFs that are passively managed (managers usually only trade shares to mirror underlying benchmarks) may have lower annual expenses than actively managed funds.
Flexible trading -- Like stocks, ETFs are sold at real-time prices and trade throughout the day. Mutual funds, on the other hand, do not have this flexibility: Their pricing is based on end-of-day trading prices.
Can be sold short and bought on margin -- Because ETFs trade like stocks, investors can use them in certain investment strategies, such as selling short and buying on margin. Traditional mutual funds do not allow shorting of stock or margin trading.
No minimum investment -- Most mutual funds require a minimum investment, whereas an investor can usually purchase as few shares of most ETFs as desired.
Diversfication -- An ETF may be a good way to add diversification to your portfolio. Buying shares of a technology sector ETF, for example, could potentially be less risky than purchasing shares of one technology stock -- an ETF may own shares of many different technology companies.
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There are a number of Web resources that you can turn to for more information about ETFs. For all of the following sites, click on the Exchange Traded Funds (ETFs) heading in the top toolbar.
Of course, as with all investments, ETFs may involve risks and other potential drawbacks. Consider these factors before investing:
The trading flexibility of ETFs may encourage frequent trading. That could lead to the possibility of mistiming the market (moving stocks in and out of the market at the wrong times).
Brokerage commissions are incurred. For this reason ETFs may be better suited for a buy-and-hold investor or someone who is buying a large number of shares at one time, rather than for an investor who uses a systematic investment program.
There may be capital gain distributions. At times some ETFs have distributed taxable capital gains usually because the managers have needed to buy or sell stocks to match their underlying benchmarks. Additionally, government bond ETFs are subject to federal income tax.
You should carefully consider the risks of different ETFs. Many sector ETFs, for instance, will tend to be more volatile than an ETF that tracks the broader market. Check with a financial professional to be sure that you understand the risks and have the most up-to-date information before investing in an ETF.
Points to Remember
- Exchange-traded funds (ETFs) offer potential benefits and risks of both mutual funds, stocks, or bonds.
- ETFs have different types of structures: Some are set up as unit investment trusts. Others are structured like open-end mutual funds, and dividends are continually reinvested.
- Advantages of ETFs include potential tax efficiency, low expense ratios, flexible trading, and portfolio diversification.
- Disadvantages of ETFs include occasional distribution of capital gains, brokerage commissions, and the potential for frequent trading, which could lead to mistiming the market.
- ETFs may be better for a lump-sum investor with a long time horizon than someone who trades frequently and/or invests at regular intervals.
1Investors in international securities are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Sector funds are subject to increased volatility due to their limited diversification compared with other stock funds.
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