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The Advantage of Exchange-Traded Funds (ETFs)

By Dr. Winton Felt

ETFs (Exchange-Traded Funds) which can be traded like stock at any time during market hours, have low expense ratios, have less risk than individual stocks, do not have some of the tax disadvantages of a regular mutual fund, do not pool investor capital, and are constructed so they are far less susceptible than standard mutual funds to the fraudulent behavior of some investors. Though they trade like stock, they are similar to sector funds and index funds in the construction of their portfolios.

If you are interested in sector and index investing or if you are a little afraid of the volatility of individual stocks, you might consider exchange-traded funds (ETFs). In a regular open mutual fund, investors buy shares directly from the fund. When they want to sell shares, they sell them back to the fund. Assets are held in a pooled account. An ETF is actually a mutual fund that trades (and is bought and sold any time during market hours) just like a stock. Investors buy shares from and sell shares to other investors just as if they were buying and selling stock. Your assets do not share a pooled account with other investors in the fund. There is no load or fee levied by an ETF when shares are bought or sold. The only costs for buying or selling are the same fees that are charged for stock transactions.

An ETF is actually a mutual fund that is traded on a stock exchange. ETFs are usually collections of stocks or bonds. For example, our own tracking list includes ETFs that combine groups of stocks in various US sectors (technology, real estate, utilities, Biotech, energy, healthcare, etc.), investment types and styles (Small-Cap Growth, Mid-Cap Value, Small-Cap value, Large-Cap growth, Consumer Non-Cyclical, US Treasuries, and so on), other countries or economies (Australia, Belgium, Germany, Hong Kong, Malaysia, Spain, Japan, etc), various multi-country regions of the world (Emerging Markets, The Pacific, Europe, Latin America), and Indexes (Dow Jones Industrial Average, S&P 500, Russell 2000, S&P 400, Dow Jones Utilities, etc), and others. A stock ETFs does not have the same kind of risk as an individual stock because it is a collection of stocks. For example, assume a utility ETF has 30 utilities in it. If any one of those utilities drops 40%, it will have little effect on your portfolio, even if your portfolio is fully invested in that one ETF. If all the other utilities in a 30-stock ETF remained constant, a 40% drop in one of those stocks would cause a drop of only about 1. 33% in your entire portfolio. Thus, ETFs would generate fewer trade confirmations from the broker because the drop of an individual stock in an ETF probably would not be sufficient to trigger a stop-loss order. The stocks in the ETF would have to go down enough as a group to set off the stop-loss. ETFs can be monitored and charted throughout the day just like other stocks.

Index ETFs closely match the behavior of their respective indexes. The behavior of sector ETFs is similar to that of no-load sector funds. The latter ETFs tend to be less volatile than individual stocks (a natural consequence of the fact that each ETF has more than one stock in it) and therefore do not have quite the profit/loss potential of individual stocks. However, the sector ETFs are more aggressive and volatile than fully diversified funds and have greater potential for profit or loss than those funds do because of their narrower focus. Though they do not have quite the same potential as individual stocks, they also have less risk and their potential for profit is nevertheless very attractive. For example, stockdisciplines.co m traders report that they have seen the Dow Jones Real Estate ETF gain over 30% in a year and the Dow Jones Technology ETF rise from about 38 to over 52 (or over 35%) between June and January.

When you invest in a regular mutual fund after it has had a gain, the price of the fund shares reflects those gains. Thus, when you buy, you are paying for those gains. The fund will distribute that gain to you (return your own money), causing the shares to drop in value from what you paid for them. You then have to pay taxes on that gain even though you did not participate in it (you are actually paying taxes on the return of your own investment capital because you did not own the shares until after the gain was made). ETFs are not like this. With ETFs you’re far less likely to get any capital gains distributions on which you have to pay taxes because most ETFs do not have active managers. In that regard, they tend to resemble indexes and index funds. Their portfolios become relatively static after the managers buy stocks representing particular indexes or sectors. For example, Barclay’s Global Investors, which has many ETFs they call iShares, reported zero year-end capital gains for [its] entire fund family in one year we checked. However, the fact that the components that make up most ETFs rarely change does not keep an individual from changing the ETF components of his portfolio as different sectors gain and lose strength, just as he would make changes in a portfolio of ordinary stocks. Of course, taxes would have to be paid if an ETF were sold at a profit, just as with any stock. Like ordinary index funds, ETFs boast ultra-low expenses and little opportunity for the big players to cheat or take unfair advantage of little players. Individuals can buy or sell an ETF anytime the market is open, so if a person decides to bail out at 3:13 p.m. he can be out before 3:14 p.m. The procedure for doing this is identical to the procedure for selling any stock.

Though many mutual funds and ETFs are managed similarly during rational markets, ETFs have a potential advantage when investors are suddenly overcome by fear. ETFs do not have to liquidate portfolio positions as shareholders redeem shares. Therefore, ETFs are better situated to ride out a wave of selling without incurring damage to the structure of their portfolios (its also not necessary for ETF managers to keep large amounts of cash available to meet the potential redemptions of frightened shareholders). Furthermore, because they are traded on an exchange like ordinary stock, they cannot be affected by the dishonest behavior of other investors in the same pooled account as is possible in most ordinary mutual funds nor by special treatment given to a few at the expense of the many. ETFs also are not subject to the illegal form of market timing that once darkened the reputations of so many mutual funds. Like traditional open-end mutual funds, ETFs distribute their earnings to shareholders in two ways. First, income dividends from interest or stock dividends are passed through to shareholders, net of expenses. Second, realized capital gains distributions (net of realized capital losses) are passed through to shareholders—usually once a year in November or December.

ETFs are completely free from scandal. The very structure of ETFs makes it extremely unlikely that investors would ever be affected by any fraudulent behavior on the part of fund managers. They are flexible investments, charge no load, and have a very low expense ratio in comparison with similar no-load mutual funds of the standard variety.