Exchange-Traded Funds (or ETF’s) are basically baskets of securities that trade in an exchange like a stock. The ETF is subject to intra-day trading and its price fluctuates throughout the day, the result of this is that an ETF will not have its Net Account Value (NAV) calculated everyday like mutual fund does. ETF’s much like everything else in investing have their advantages and disadvantages. Let’s take a look at the advantages of ETF’s.
Trades like a stock: Unlike mutual funds, the investor is in control of what he/she wants to trade and when something that cannot be done with a mutual fund. It also gives the advantage of trading intra-day, which could be used to direct your ETF towards short market movements.
Low expense ratios: Although ETF’s are cheaper than some mutual funds, please keep in mind that ETF’s trade through brokerage firms and that each trade will carry a commission. Shop for a discount brokerage firm and you will save a lot of your hard earned money.
Tax efficiency: ETF’s have less exposure to capital gains taxes than mutual funds do. Mutual fund managers trade portfolios and knowing that the client will pay the taxes. The same happens with ETF’s but at a much smaller rate.
There’s approximately 500 ETF’s all over the world, which gives you the variety in fund selection you need. Now let’s look at the disadvantages of ETF’s.
Commissions: The flexibility offered by ETF’s comes with a price. Brokerage firms will charge a commission for every trade (buy or sell) made by the investor.
Bid/Ask Spread: Because it trades like a stock, ETF’s are subject to the ask/bid spread that stocks are subject to.
Some of the most popular ETF’s are:
1. SPDRs (SPY)
2. iShares MSCI Japan Index (EWJ)
3. iShares MSCI EAFE Index (EFA)
4. Diamonds (DIA)
It is important to notice the performance of some of these EFT’s compared to the indexes. For example, the SDPR Trust (SPY) has a YTD return of 15.05% compared to 14.49% of the S&P 500, in a 5-year span the SPY outperformed the S&P 500 with a 75.16% compared to 71.51% of the S&P. Another ETF is the Powershares QQQ Trust (QQQQ) with a YTD return of 27.72% compared to a 14.49% of the S&P. The QQQQ had a 5-year return of 114.61% compared to a 71.51% of the S&P.
It is important that the investor is aware of the benefits and risks related to investing in ETF’s and any other investment product. While ETF’s continue to grow at a steady rate it is important for the potential investor to know all the funds that are available to him/her and all the aspects related to that fund. Whether you invest in ETF’s or not, make sure you get to know more in depth the different trading strategies with ETF’s as this will add another item to your investing toolbox.