Exchange-traded funds (ETFs) are securities that closely resemble index funds, but can be bought and
sold during the day just like common stocks.
These investment vehicles allow investors a convenient way to purchase
a broad basket of securities in a single transaction. Essentially, ETF so offer the
convenience of a stock along
with the diversification of a mutual fund.
HOW IT WORKS (EXAMPLE):
Exchange-traded funds are some of the
most popular and innovative new securities to hit the market since the introduction of the mutual fund.
The first ETF was the Standard and Poor's Deposit Receipt (SPDR, or "Spider"), which was first
launched in 1993. Purchasing Spiders gave investors a way to mimic the
performance of the S&P 500 without having to purchase an index fund. Furthermore, because they traded like a stock, SPDRs could be bought and sold throughout the day, purchased
on margin, or even sold short.
Whenever
an investor purchases an ETF, he or she is basically investing in the performance of an underlying bundle of securities --
usually those representing a particular index or sector.
Unit Investment Trusts (UITs) are often organized in the
same manner. However, the unusual legal structure of an ETF makes the
product somewhat unique.
Exchange-traded
funds don't sell shares directly to investors. Instead, each ETF's
sponsor issues large blocks (often of 50,000 shares or more)
that are known as creation units. These units are then bought by an
"authorized participant" -- typically a market maker, specialist or institutional investor -- which obtains shares of the underlying securities and places them in a trust. The authorized
participant then splits up these creation units into ETF shares --
each of which represents a legal claim to a tiny fraction of the assets in the
creation unit -- and then sells them on a secondary market.
Just
as closed-end funds don't always trade at a price that precisely reflects the
value of the underlying assets in each share of the portfolio, it is also
possible for an ETF to trade at a premium or a discount to its actual
worth. To liquidate their holdings, most investors simply sell
their ETFshares to other investors on the open market. However, it is possible to amass enough ETF shares
to redeem them for one creation unit and then redeem the creation unit for the
underlying securities. Because of the large number of shares involved,
individual investors seldom use this option.
WHY IT MATTERS:
Exchange-traded funds have grown increasingly popular in recent years, and the
number of offerings has swelled. Today, these securities compete with mutual
funds and offer a number of advantages over their predecessors,
including:
Low Cost -- Unlike
traditional mutual and index funds, ETFs have no front-
or back-end loads. In addition, because they are not actively
managed, most ETFs have minimal expense ratios, making them much more
affordable than most other diversified investment vehicles.
Most mutual funds also have minimum investment requirements, making them impractical for some smaller
investors. By contrast, investors can purchase as little as one share of
the ETF of their choice.
Liquidity -- Whereas traditional mutual funds are
only priced at the end of the day, ETFs can be bought and sold at any
time throughout the trading day. Many have average daily trading volumes in the
hundreds of thousands (and in some cases millions) of shares per day, making them extremely liquid.
Tax-Advantages --
In a traditional mutual fund, managers are typically forced to sell off
portfolio assets in order to meet redemptions. Often, this act triggers capital gains taxes,
to which all shareholders are exposed. By contrast, the buying and selling of
shares on the open market has no impact on an ETF's tax liability, and those that choose to redeem their ETFs are paid in
shares of stock rather than in cash. This minimizes an ETF's tax burden because it does not have
to sell shares (and therefore potentially realize taxable capital gains) to
obtain cash to return to investors. Furthermore, those who redeem their ETFs are
paid with the lowest-cost-basis shares in the fund, which increases the cost basis for the remaining
holdings, thereby minimizing the ETF's capital gains exposure.
Although
exchange-traded funds offer several advantages over traditional mutual
funds, they also have two distinct disadvantages. To begin, the securities that
an ETF tracks are largely fixed, so investors that prefer active management will probably
find ETFs wholly unsuitable. Furthermore, because they trade as stocks, each ETF purchase will be charged a brokerage commission. For those that make regular periodic investments -- such as a monthly dollar-cost averaging investment plan
-- these recurring commissions might quickly become cost-prohibitive.
As
with any security, the pros and cons should be weighed carefully, and investors
should first do their homework to determine whether exchange-traded funds are
the appropriate vehicle to meet their individual goals and objectives.
No comments:
Post a Comment