ETF - BASICS

The exchange-traded fund, better known as an ETF, is the mutual fund
for the twenty-first century. Like mutual funds, ETFs hold a diversified
portfolio of stocks, bonds, or some other asset class. Yet, their structure is different enough that almost every ETF is less expensive, more tax-efficient, more transparent, and more flexible than any comparable mutual fund. That means more money for you. And in the end, isn’t that what investing is all about, having more money in your pocket?
You need to prepare for retirement. You might need to save for your child’s education. You might just want to grow capital to buy some other big expenditure, such as a house, a car , or a vacation. Whether you’re the kind of person who likes to manage his or her own finances or who just wants to understand what your investment advisor is talking about, this book is for you. I will explain, in easy-to-understand language, why you should be investing in ETFs over almost any other investment vehicle. No use any mathematical formulas is done here.
Investing and increasing your assets is difficult. It means having to choose from a multitude of choices and decide which will be a winner. It’s taking a risk on the unknown and then waiting. Basically, it’s predicting the future, and that’s hard to do well. Investment advisors tell you this is a very complex process, and thus individual investors need their services to navigate these difficult waters. But it doesn’t have to be that way. It can be very simple if you follow a systematic approach. One way to simplify your investing life is to buy ETFs. Mutual fund investors know that funds are great investment vehicles. Buying mutual funds is much easier than buying individual stocks. You get a professional manager to do the hard work for you. Plus, they offer diversification with a low minimum investment.
With more than 8,000 mutual funds on the market, you can buy a portfolio to suit any strategy. A single fund can hold as few as 20 underlying securities or thousands.
High fees are a huge offense mutual funds commit against their own shareholders. In investments, high fees can mean the difference between earning an annual profit or a loss. And the more fees decrease the size of your investment, the longer you will need to save. So, if you found an investment very similar to a mutual fund for a much lower price, would you buy it? Of course you would.
ETFs are that product.
ETFs offer everything a mutual fund does, and usually cost less to own. With the flexibility to trade during the hours of the stock market, and daily portfolio transparency.
If you’re one of those hedge fund investors who believe that you get what you pay for, then ETFs are not for you. Unregulated hedge funds offer the potential for huge profits for people who can make a minimum investment in the millions of dollars and stomach massive amounts of risk. With no transparency, the hedge fund investor has no idea what he owns and it can often take weeks or months to get his money out. You need to be rich to invest in hedge funds because there is a much greater risk of their blowing up.
Most investors can neither manage the minimum investment nor stom-
ach the risk of a hedge fund. ETFs are the opposite of hedge funds. These highly regulated funds are much safer than hedge funds. They are open to anyone, very liquid, highly transparent, much cheaper to own, and filled with the potential to beat hedge fund returns with much less risk.
This isn’t to say ETFs have no risk. Like hedge funds and mutual funds, ETFs are as risky as the assets they hold. So an ETF tracking the broad market benchmark, the S&P 500 Index, would be much less risky than an ETF with just companies from the biotechnology industry. The ETF tracking the S&P 500 would have the same amount of risk as a mutual fund tracking the same index, while a biotech ETF would be just as risky as any biotech sector mutual fund. Meanwhile, an ETF holding bonds would typically have less risk than a mutual fund owning equities, and vice versa.
ETFs—The Newfangled Mutual Funds

How ETFs Stack Up against Mutual Funds
ETFs combine many features of a mutual fund into a tradable stock, making the claim “new and improved” much more than a marketing ploy. The top six benefits that exchange-traded funds offer over mutual funds:

1. greater flexibility
2. lower fees
3. increased tax efficiency
4. greater transparency
5. ability to invest in more asset classes
6. ability to create more precise tactical investment strategies

Greater Flexibility
The biggest improvement and most important benefit that ETFs offer over
mutual funds is the ability to be traded on a stock exchange. This is a
huge advantage. Trading offers greater flexibility by allowing individual
investors to buy and sell when they choose, as opposed to the once-a-day
option offered by mutual funds. Because they trade on a stock exchange
for the entire market session, the price of an ETF fluctuates all day long.
This may seem like more of an advantage to day traders and institutional
investors, who are most likely to hold funds less than one day, but in fact
this flexibility is a great benefit for buy-and-hold investors. The ETF investor
can pinpoint the exact price at which he or she wants to buy or sell their
investment.
That’s not the case with mutual funds. Mutual funds can only be bought or sold from the fund company once a day—after the 4 P.M. market close—at one price, the net asset value, or NAV. The NAV is basically the average price of all the shares in the fund, but it isn’t calculated until after all the stocks have closed for the day. This leaves mutual fund investors at a distinct disadvantage. Investors must decide during a trading session to buy or sell a fund without knowing what the price will be.

For example, say the stock market receives a very negative economic report at 10:00 A.M. Most likely the market would begin a drastic move lower. Now compare the different experiences on that same hypothetical day of an ETF investor and a mutual fund shareholder, who each have portfolios of $100,000. Both investors are tuned into the financial news, so both become aware of the report at the same time. The news provides the catalyst for a major market sell-off that by the end of the day will send the Standard & Poor’s 500 index 2 percent lower.
At 10:05 A.M., the mutual fund investor calls his fund company and says he wants to sell all the shares in his fund. The company tells him that they will be sold at the NAV calculated after the trading session ends. So, even though the mutual fund investor tried to get out quickly by calling his fund company early in the day, it doesn’t matter. The fund calculates the sale price after 4 P.M. By that time, the market has already fallen, and the NAV is calculated with all the lowered stock prices. The likelihood is that the fund sells the investor’s shares at the lowest price of the day.
Meanwhile, the ETF investor calls his stockbroker at 10:05 A.M. and tells the broker to sell all his shares. Because the ETF trades all day long, the broker makes a market order to sell the shares immediately. Even though the market falls 2 percent by the end of the day, the ETF investor gets out before most of the damage occurs, locking in a price near the high of the day. With our hypothetical portfolios, the ETF investor walks away with nearly $2,000 more than the mutual fund investor. The same scenario would also apply in an up market. The ETF investor buys early in the rally and profits from the day’s rise. Meanwhile the mutual fund investor may see the rally, but cannot enter during the trading session. Instead, his share price is determined after the market rallied. Essentially, he buys near the top.
This ability to catch the beginning of a market move rather than only its conclusion gives investors greater profit potential. This flexibility also allows ETFs to be bought or sold with a market , limit, or stop-loss order, or on margin. Many ETFs also offer tradable put and call options. Another option not available to mutual fund shareholders is the ability to sell short. An investor can sell short an ETF or stock in anticipation of a downward move in the shares. The investor borrows the shares from a broker, then sells the shares first with the hope of closing the transaction by buying them back later at a lower price.
Greater flexibility gives the investor both more control over the purchase and sale price of the investment and an opportunity to take advantage of market moves.

Lower Fees
ETFs are essentially index funds. Index funds track a particular market by holding a basket of the exact same securities as the index, or an extremely close approximation.
The first ETF, the Standard & Poor’s Depositary Receipt (better known
as the SPDR, or Spider) began trading in 1993. It tracked the S&P 500, the
very vanilla, U.S. large-cap stock index. Subsequent ETFs followed other
major market indexes, such as DIAmonds, which follows the Dow Jones
Industrial Average, and the PowerShares Triple Qs or Cubes (Qubes), which
track the NASDAQ 100 Index. At the end of 2007, all ETFs were required to
follow an index.
Because these baskets of stocks follow indexes, they are passively man-
aged with infrequent asset turnover. Like index mutual funds, this results in extremely low annual expense ratios; in addition, the fees for ETFs are often lower than even those for the corresponding index funds. For instance, the Vanguard 500 Index fund, the largest and oldest index fund available to re-
tail investors, tracks the S&P 500 Index. It has one of the lowest annual fees among mutual funds: only 0.18 percent of assets. Compare that with two ETFs, the Spider and Barclay’s iShares S&P 500 Index, which charge a mi-
nuscule expense ratio of 0.08 percent and 0.09 percent, respectively. These are half Vanguard’s fee. And Vanguard’s tiny fee is the exception among mutual funds. Most mutual funds charge management fees of more than 1 percent, and some are as high as 5 percent. Currently, no ETF charges more than 1 percent. Fees are one of the biggest wealth destroyers for investors, so small fees add up to significant savings over time.
“Why is it so difficult to capture the market’s returns? Because the market
returns we read about ignore the costs of investing,” says John Bogle, the
founder and former chairman of the Vanguard Group, and the creator of the
Vanguard 500 fund. “In the search for the Holy Grail of superior returns, real-
life investors incur heavy costs—fund management fees, operating costs,
brokerage commissions, sales loads, transaction costs, fees to advisers, out-
of-pocket charges, and so on. Performance comes and goes, but costs roll
on forever.”
More Tax Efficient
The third major benefit that ETFs hold over mutual funds is greater tax efficiency, primarily by delaying taxes on capital gains. Whenever a mutual fund, even an index fund, sells a security, it is a taxable event. All profits are capital gains. Profits earned by mutual funds, pass through the fund to the individual shareholders. And when a shareholder earns capital gains, he or she must pay capital gains taxes. Even if index-fund investors hold their funds for decades, every year they must pay taxes on the capital gains that the funds incur during the previous 12 months.
Capital gains taxes can be especially onerous when many investors pull their money out of a fund, as occurred in the wake of the stock market’s dotcom crash in 2000. As investors pulled their money out, mutual funds were forced to sell their underlying assets in order to cash out these investors. To add insult to injury, the investors who chose to stay in the funds took a double hit. Not only had their investments fallen in price, but as the other investors left, the ones who stayed were stuck with paying the capital gains taxes from all the stock the fund needed to sell.
Meanwhile, because ETF investors own shares in their own personal
accounts, rather than investing in a fund’s pool of assets, their investment
isn’t connected to any other shareholder. ETF investors therefore only pay
capital gains taxes when they sell their shares. Delaying the payment of
taxes can make a significant difference in overall returns. When an investor
isn’t forced to pay out part of their principle in taxes every year, that means
there is more principle to grow. In addition, the buy-and-hold investor who
doesn’t sell his ETF until after retirement may find himself in a lower tax
bracket.
Greater Transparency
Transparency means that at any specific moment, investors have the ability to see the price and holdings of the ETF.
Because they are index funds, it’s reasonably easy to determine what stocks are included in an ETF or index mutual fund: simply look at the index. Of course, sometimes ETFs and index funds don’t hold every single stock in the index. How far an index mutual fund veers away from the index is not apparent, but with ETFs you always know what stocks are held.
Due to its unique structure, the ETF must make available every day a
list of all the securities that make up the fund, so that new shares can be
created.
Mutual funds have a measure of transparency, but even that is a bit
dubious. The portfolios of mutual funds are not transparent on a daily basis.
Every six months the mutual fund is required to send to its shareholders
a list of its holdings. This means shareholders see what’s in the fund only
twice a year, and even then, the report is suspect. Funds are given 60 days
to deliver this list to shareholders. Because mutual funds are allowed to buy
and sell securities every day, the portfolio documented at the end of the
six-month period is often not the same as the one actually held 60 days
later.
The transparency of the ETF’s portfolio during the trading session gives the investor the ability to see the ETF’s share price above, the ability to see the share prices gives the investor greater control over the purchase and sale of the investment.

Precise Allocations
Transparency allows investors to create precise strategic asset allocations and tactical investment strategies. While all mutual funds have an investment strategy they must follow, it’s not uncommon for a fund manager to sometimes stray from the strategy. This can happen for a variety of reasons. If the investment strategy is out of favor, the manager might want to hold some stocks on the rise in order to boost his returns.
Transparency allows the investor to see exactly what his holdings are
on a daily basis. This is important because a group of mutual funds with
different investment objectives may actually hold the same or very sim-
ilar securities. Thus, with mutual funds the investor could inadvertently
be overweight in areas of the market that are not advantageous to the
portfolio.
For example, you own a large stock mutual fund and a small stock
technology fund. However, small stocks aren’t doing well, so the mutual
fund manager buys some large tech stocks that are doing well. However,
this could cause the investor’s portfolio to have a greater weighting in large
tech stocks than he wanted. Because fund managers have a lot of leeway
and their portfolios are typically hidden from view, the investor is at a
disadvantage.
Most ETFs track an index. This is an advantage because it restricts what the ETF can hold. By knowing exactly what each ETF holds, the investor can make very precise asset allocations for his or her portfolio. The investor can fine-tune the portfolio to hold the exact amount of large stocks, small stocks, and international stocks he or she wants, without overlap or overweightings.
Investment in Alternative Asset Classes
Finally, ETFs offer another big benefit for individual investors—the ability to buy alternative asset classes as easily as stocks. This benefit doesn’t easily roll off the tongue of the person advocating ETFs, but it may be the biggest boon to individual investors since the creation of the original ETF.
In the past, commodity and currency markets were difficult for individual investors to enter. But as the world economy changes, these asset classes have taken on greater significance. To not have the opportunity to take advantage of these asset classes is a severe disadvantage to small investors. But companies using the ETF structure have given the investor the ability to participate in these markets with the same ease and minimal investment as the ETF itself.
With increased demand for gold, oil, and other commodities, as well as foreign currencies, investors have more tools with which to create more diversified portfolios.
One Caveat
For all the laudatory benefits of ETFs, in some cases mutual funds may actually be preferred. ETFs have one big drawback: the price of admission. Because they trade like stocks, they can only be bought or sold through a stockbroker, who, of course, charges a commission. Even with a discount broker, these transaction costs can eat into principle, making ETFs prohibitively expensive for adherents of dollar-cost averaging, one of the mainstay strategies for long-term investing.
While mutual funds sold through brokers carry commissions, known
as loads, savvy investors know to stay clear of those and invest in no-
load funds. With no-loads, every investment dollar lands in the fund and
not in a broker’s pocket, maximizing the investment. And no-loads don’t
charge a fee to sell. So dollar-cost averaging remains the index funds’ ace in
the hole.