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Introduction to Exchange Traded Funds

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Exchange Traded Funds, or ETFs, are index funds that trade just like stocks on major stock exchanges. If you want to invest in the market quickly and cheaply, ETFs are the most practical vehicle. They help the investor focus on what is most important…choice of asset classes.

There are now approximately 1,000 publicly traded ETFs. There are ETFs for large US companies, small ones, real estate investment trusts, international stocks, bonds, precious metals, etc. Pick an asset class that is publicly available and there is a good bet that it is represented by an ETF.

ETFs differ fundamentally from traditional mutual funds, which do not trade midday. Traditional mutual funds take orders during Wall Street trading hours, but the transactions actually occur at the close of the market. The price they receive is the sum of the closing day prices of all the stocks contained in the fund. Not so for ETFs, which trade instantaneously all day long and allow an investor to lock in a price for the underlying stocks immediately.

With approximately 70% to 80% of all traditional mutual fund managers under performing the market indices, some Wall Street sages believe that these powerful instruments may make mutual funds obsolete someday. Hyperbole aside, however, ETFs are certainly a powerful investment vehicle.

Asset Allocation and Diversification

The importance of asset allocation, or deciding what percentage of a portfolio to devote to various asset classes, cannot be overstated. Investors spend enormous amounts of time and money picking individual stocks, while they spend relatively little deciding what types of stock or bond to their funds. It should be just the opposite.

Investors should spend most of their time on overall asset selection and ignore individual stocks for the most part. Repeated studies by unbiased university researchers have shown that about 95% of money managers' performance, for better or worse, can be explained by their selection of asset classes, not by their selection of individual stocks. When a stock performs well, invariably stocks from the same asset classes follow in parallel. All one has to do is pick asset classes well to outperform. Asset allocation is not necessarily easy, but it is less detailed and time consuming than stock picking, and it rewards the diligent investor handsomely.

Why is stock picking so unproductive? Most economists feel this is because of the enormous competition in the markets. So many experts are analyzing stocks that there is no public information others have not examined and acted on. Insider information probably would give an advantage but it is, of course, illegal to use for trading. The sheer cost of sifting through information about individual companies raises the hurdle further for stock picking funds to beat the market. One strategy to avoid the crush of competition is to gravitate to lesser-known companies, but this brings with it higher risk. The record clearly shows that on average stock picking funds do not beat the market, and there is no evidence that stock pickers who are initially successful can maintain their edge over time. Happily, ETFs are the ideal tool for the investor focused on asset allocation. They represent just about every asset class available and are cheap, liquid, and reliable.

Easy and Inexpensive to Trade

ETFs are economical to buy and especially to maintain over the long run, making them especially attractive for the typical buy-and-hold investor. Annual fees are as low as .09% of assets, which is breathtakingly low compared to the average mutual fund fees of 1.4%. Although investors must pay a brokerage transaction to purchase them, with discount brokers this becomes negligible with sizable trades. There are a few easy-to-avoid pitfalls to watch out for. Tax effects are also not to be ignored, and ETFs perform well after-tax. They can be traded on margin, and options based on them allow for various defensive (or speculative) investing strategies.

Their safety as a securities instrument (considered separately from the safety of any particular asset class they might represent) is considered the same as stock certificates themselves. Internally, ETFs are far more complex entities than mutual funds. A fascinating combination of players, including brokers, money managers and market specialists combine to make them run smoothly. Legally, ETFs are a class of mutual fund as they fall under many of the same Securities Exchange Commission rules that traditional mutual funds do. But their different structure means that the SEC has imposed different requirements from traditional mutual funds in how they are bought and sold.

ETFs are index funds at heart, so investors are encouraged to study the philosophy of index investing, which downplays stock picking in favor of buying the market. But unlike most traditional index funds, investors need not take a passive, buy-and-hold approach. ETFs are also becoming favorites of hedge funds and day traders who like to pull the trigger frequently. Both types of investors may coexist and in fact strengthen each other by lowering overall transaction costs.

Tax Efficiency

Another benefit to trading ETFs is that they are quite tax-efficient. Because of the way they are created and redeemed, they allow an investor to pay most of his capital gains upon final sale of the ETF, delaying it until the very end. There is no way to avoid capital gains, but delaying it is valuable because the amount that would have been paid to taxes can continue to accumulate wealth. Exactly how much an investor benefits after-tax depends on their marginal tax rate, the return of the investment, and how long they hold the investment. Overall, ETFs are similar to tax managed index mutual funds, slightly more efficient than standard mutual funds, and significantly more efficient than actively managed mutual funds.

Traditional mutual funds accumulate unrealized capital gains liabilities for stocks that have risen in value. Upon sale of these stocks the fund calculates and periodically distributes the capital gains to its investors in proportion to their ownership. The problem with this is if you buy into a traditional mutual fund today that has owned Wal-Mart or Microsoft for decades, you'll be buying a tax liability, even though you haven't reaped the gains.

ETFs have modest distributions in comparison to actively managed mutual funds. Additionally, the more turnover an actively managed fund has from trying to pick stocks, the more it will force investors to pay the IRS. It's an ugly, and little discussed, fact that active mutual fund investors can end up paying other investors' tax bills, especially in a bear market. That's because investors who sell out before the day of record for that distribution will not receive the tax bill, while loyal investors who stay in will pay it for the entire amount!

Why are ETFs are so efficient? From a regulatory standpoint, ETFs are comprised of trading equivalent certificates for what are called in-kind trades. This exchange of essentially identical items does not trigger capital gains, according to the IRS. Traditional mutual funds must go into the open market and exchange cash for stocks and vice versa, which trigger realization of gains. It's a subtle difference that results in an advantage for the ETF investor. As always, there are exceptions. Occasionally an ETF fund that is only a few years old may throw off unusually high distributions, in a market downturn. But this is not typical.