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Chapter 14 — EXCHANGE TRADED FUNDS
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EXCHANGE TRADED FUNDS

EXCHANGE TRADED FUNDS

An Exchange Traded Funds (ETF), is an investment instrument made up of securities that usually follows an index. An index is a hypothetical portfolio that tracks a broad sector of the market. For example, one of the most popular ETFs is the Standard & Poor’s Depositary Receipt (SPDR S&P 500) which tracks the S&P 500 index. The SPDR S&P 500 serves to replicate a portfolio that contains the S&P 500 stocks.

Exchange Traded Funds (ETF)

Other Exchange Traded Funds track other indices, such as the QQQQ, which tracks the value of the NASDAQ 100 Index. And the Dow Jones Industrial Average fund, known as “Diamonds” or DIA, which tracks the Dow Jones Industrial Average index. Some Exchange Traded Funds also track stocks from particular industries, international assets, commodities, currencies, and various other subgroups of the market.

Exchange Traded Funds are very similar to mutual funds, with the exception that an individual ETF is traded throughout the day like stock rather than a portfolio of stocks. Since Exchange Traded Funds are traded like stocks, they can be bought as well as sold short. In theory, an Exchange Traded Fund that tracks the S&P 500 should have a very similar performance to an S&P 500 index mutual fund. However, because an ETF is traded like a stock, it is not actively managed like a mutual fund. ETFs are also more closely related to a closed-end fund because there are a fixed number of traded shares.

ADVANTAGES AND DISADVANTAGES OF EXCHANGE TRADED FUNDS

Since Exchange Traded Funds are somewhat like mutual funds, they share many of the benefits of MF. Like mutual funds, one of the biggest advantages of Exchange Traded Funds is diversification. Since ETFs generally track indexes, they are more diversified and exposed to less risk than single stocks. However, some ETFs, such as ones that track a particular industry, are more exposed to certain risks since negative news concerning the industry will affect all of the stocks in the Exchange Traded Fund.

Because ETFs trade like stocks, they are not susceptible to certain restrictions placed on MF. For one, since Exchange Traded Funds are not actively managed, they do not require high management fees like mutual funds.  However, investors often will still pay a brokerage commission when buying or selling an Exchange Traded Fund.

Unlike mutual funds, ETFs have low turnover. Turnover refers to the frequency a stock within a portfolio is bought or sold. Because Exchange Traded Funds generally track an index, the portfolio of assets it holds only changes when the index changes. Since ETFs are not actively managed, if one particular stock underperforms, you cannot simply sell it from the ETF. Furthermore, while one can easily transfer funds from one mutual fund to another, Exchange Traded Funds do not have such flexibility. Here are some other specific advantages and features of ETFs:

NO MINIMUM

Most MF often require a minimum investment. Since ETFs trade like stocks, there is no minimum required. You can purchase as few or as many shares of an ETF as you wish.

TRADES LIKE STOCKS

ETFs are traded like stocks. As such, they share many advantages that stocks have. Unlike mutual funds which can only be bought or sold at the end of the day for its net asset value, ETFs can be traded any time the market is open. You can place limit orders, stop-loss orders, buy/sell on margin, and pretty much anything else that you can do on a stock. They also share greater liquidity than mutual funds.

OPTION TRADING

Many Exchange Traded Funds also have options. ETF options provide investors with more flexibility and more trading strategies. All of these features are not present in mutual funds.

THE TAX BENEFITS

Another great advantage of ETFs is that they are very tax-efficient. Each time a stock is sold within a mutual fund, a capital gains tax is paid to the government. Therefore, mutual fund returns are often diminished due to capital gains tax. When a stock is removed or sold within the ETF due to changes in the index it’s tracking, the capital gains tax is held off until the entire ETF is sold. Thus, the investor is not taxed for the readjustments within the ETF, allowing the investors to keep more money in their pockets.

HOW TO INVEST IN ETFs?

Because of the popularity of ETFs, they are very easy to find. Just about every brokerage firm that handles stocks also allows investors to trade ETFs. To invest in an ETF, first, choose a brokerage and open an account. Depending on your preferences, you can either choose a traditional brokerage firm that offers investment advice or a discount brokerage where you will pay fewer fees but will not receive professional expertise and guidance. Once the account is open, you can research and invest in ETFs much like you can with stocks.

Quiz

All of the following are features of ETFs that make them more desirable investment instruments EXCEPT:

Correct
Incorrect
0/76 (0%) Correct
  • 1
    They are taxed at a lower rate
  • 2
    The government does not charge ETFs a capital gains tax at all
  • 3
    The capital gains tax for stock adjustments are held off until the entire ETF is sold
  • 4
    Mutual funds are actually more tax efficient than ETFs
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