Blog for Trading Success

Cross ref: www.awanginvest.com

June 24, 2008 – 12:00 am

EXCHANGE-TRADED FUNDS –ETFs

SGX :

Headlines such as this bombard us in the ads almost daily:

Market Makers: The Wisdom Of Steinberg Aided by two industry legends, here’s how Jonathan Steinberg transformed an ailing publishing business into an ETF juggernaut.

Beyond the hype, an ETF is not for every one.

We need to consider what is an ETF.

ETFs are basically index mutual funds that trade like stocks. When you buy an ETF, you own a single security that represents a basket of stocks, tracks an index and fluctuates with the value of the underlying stocks.

With an ETF, you place an order to buy or sell shares just as with any other stock—and you pay a commission on that trade. This means you can buy an ETF at its current price anytime during the trading day. In contrast, you can only buy an index fund at the closing price.

ETFs also tend to be more tax-efficient than index funds. One example is the oldest ETF, the S&P 500 Depositary Receipt (SPY). Often abbreviated as SPDR and pronounced “spider,” it had average capital gains distributions of less than 0.02% of invested assets during the past 12 years versus. an average 0.35% for the largest three S&P 500 index funds.

Another advantage of ETFs is that they are not required to keep return-dampening cash on hand for redemptions, unlike mutual funds.

When do you choose ETFs?

• Investing a large amount of cash in an index
• Getting exposure to a sector or asset class at a low cost
• Putting excess cash to work.

When do you choose Mutual Funds?

• Investing small amounts of money at a time
• Seeking an index-beating return.
• Investing in certain categories – Mutual Funds number 10,000 against 600 ETFs.

Now that you know that ETFs are basically index mutual funds that trade like stocks, have low expenses and are easy to trade, are a cheap, easy, tax-efficient way to get good diversification, it is not all what it appears to be.

THERE ARE MYTHS TO CONTEND WITH:

• Myth No. 1: All ETFs have low expenses.
• ETFs will also have a transaction fee that you pay when you buy or sell—just like when you trade a stock. Mutual funds may have a transaction fee as well as a sales charge.
• Myth No. 2: All ETFs are easy and cheap to trade
• For ETFs that are actively traded all day long, the bid-ask spread tends to be quite small. But less-liquid ETFs tend to have much larger spreads.
• Myth No. 3: All ETFs are index funds.
• Some indexes are effectively and actively managed; the company that puts the index together tries to include only stocks that it believes will outperform the market. This leaves you open to the possibility that the people or companies assembling the index will be wrong about which stocks will outperform. That is called active management risk, and avoiding that risk is one of the features of indexing that some ETFs fail to provide.
• Myth No. 4: All ETFs are tax-efficient.
  Much has been made of the tax-efficient nature of ETFs, and it’s true that they are often more tax-efficient than similar mutual funds. The main reason for this is that ETFs usually will not be forced to distribute capital gains to shareholders; just because a fund is an ETF does not mean that you will avoid all taxes as long as you hold it. Many ETFs still pay out dividends and interest to shareholders, and these payouts are taxable.
• Myth No. 5: All ETFs give you diversification.
  Finally, you may like the easy diversification provided by an ETF—by making one trade, you suddenly have a well-diversified domestic equity portfolio. Very narrow ETFs may provide you with very little diversification.

So these are the myths debunked.
Not all ETFs are alike. While many ETFs are good tools for providing inexpensive, highly liquid, tax-efficient diversification without taking on active management risk, some ETFs fail to live up to this billing.

CAVEAT EMPTOR: YOU must consider carefully what it is you want from an ETF before you buy and that the ETF delivers.

ANA aka IDKIT

AG MODERATOR

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