Sunday, February 17, 2013

What is ETFs (Exchange Traded Funds) and How does it Work

Understanding ETF, Definition of ETF
Exchange-traded funds, or ETFs, have earned a place in the portfolios of millions of investors because of their low cost and convenience.
An ETF is simply a basket of securities, usually stocks, that is designed to track a market benchmark. It may follow a broad-based index such as the Standard & Poor's 500, or a more specialized area, such as health care companies or Chinese stocks. About 2% of US households hold ETFs, according to the Investment Company Institute, a trade group for US investment companies. As their name suggests, ETFs are traded on the stock market, so they can be bought and sold just like regular shares of stock.
At the end of 2007, there were 629 exchange-traded funds with total assets of about $608 billion, according to the ICI. The funds are fairly evenly divided into three categories: broad-based stock funds, industry-specific funds and international stock funds. There are also about 50bond ETFs that track indexes of corporate or government debt.
Because ETFs are suitable to many kinds of investors, they have become one of the investment industry's fastest-growing products. From 2005 to 2007, assets in ETFs doubled, and the number of funds tripled, according to the ICI.
Spyders and Other ETFs
The largest exchange-traded fund as of May 2008 was the SPDR Trust, which tracks the S&P 500 and trades on the American Stock Exchange. "Spyder," as it's called, got its start in 1993, making it the oldest exchange-traded fund. Other large ETFs include the iShares MSCI EAFE fund, which follows a benchmark of foreign stocks in the developed countries of Europe, Australasia and the Far East, and the iShares MSCI Emerging Markets fund, which invests in stocks in developing countries.
More recently, the trend in ETFs has led to greater segmentation and the creation of highly specialized portfolios, such as the WisdomTree Dreyfus Chinese Yuan Fund, which can be highly volatile, making them less suitable for mainstream investors seeking broad-based diversification.
ETFs are close relatives of index mutual funds and offer the same advantages of diversification and convenience that have made funds a popular investment choice for individuals. Because these funds simply buy securities listed in a given index, investors can avoid the expense of paying a manager to select investments on the basis of research. Lower fees are one of the main reasons why low-cost index funds have provided above-average returns to investors, according to Vanguard Group. As of 2007, index mutual funds held about $200 billion more in assets than ETFs.
Companies that offer exchange-traded funds include:
  • Barclays Global Investors
  • State Street Global
  • Bank of New York
  • Vanguard Group
  • Fidelity Investments
ETFs vs. Index Mutual Funds
Some investors may find ETFs better suited to their needs than mutual funds. According to Vanguard Investments, ETFs are beneficial to investors who:
  • intend to buy a fund and hold it for the long term.
  • have a large amount of money to invest at once.
  • need the flexibility to buy and sell funds throughout the day.
Index mutual funds, however, may be preferred by investors who:
  • wish to rebalance their portfolio on a regular basis.
  • plan to invest fixed amounts over time, a method known as dollar-cost averaging.
  • don't have a lot of money to invest right away.
Hidden Costs of Dollar-Cost Averaging
ETFs often have lower costs than mutual funds that cover similar segments of the market, but that advantage can vanish when fees are taken into consideration. For instance, if your broker charges a $10 commission for a trade, you could pay $120 a year to make regular monthly investments in an ETF. Many mutual funds waive fees for recurring investments.
No Minimums on ETFs
ETFs can be bought in small increments, one share at a time. Most mutual funds, however, require minimum initial investments. As a result, for new investors with few assets, an ETF may be the simplest way to begin building a portfolio of indexed investments.
Trading During the Day
Mutual funds receive only one price per day, at the close of trading. That makes it difficult to move in and out of mutual funds during the day. The price of exchange-traded funds fluctuates throughout the day. As a result, it's possible to trade these funds at any point during market hours. Keep in mind that commissions apply to all trades of ETFs and that these fees can erode your total return.
Kicking the Tires on an ETF
When considering a specific ETF investment, the same questions apply as with mutual funds. You'll want to determine which index the fund tracks, and what the largest holdings of the fund are. Also, find out how expensive it is to own the fund as measured by its expense ratio, then look at the performance of the fund over both the short term and long term. Other factors to consider are the fund's dividend yield, a measure of how much income it generates from dividends and its total assets. In general, funds with larger assets can charge lower fees.