Index investing through mutual funds has for a long time been criticized for its high costs such as brokerage expenses, management fees and load structures. The advent of the ETF or Exchange Traded Fund has brought about a change in this scenario.
An exchange traded fund is similar to a mutual fund, the only difference being that it is traded like common stock. It is actively traded on an exchange at prices that are closer to the net asset value of the underlying security which may be a group of stocks like an index or a commodity. Almost all the major indices and commodities like gold have ETFs that mimic their prices. An ETF is actively managed by a professional money manager. It usually copies or follows the movement of an index. For example, the S&P 500 has the ETF 'spider' SPDR; the ETF 'ishares' is managed by Barclays Global Investors and the Vanguard Groups has the ETF 'VIPERS'. All these ETFs track the values of the index in real time. ETFs are cost-effective because:
• They offer trading options like in common stock where you can sell short, use a limit order and stop loss orders as ways to control losses.
• You can buy ETS on margin.
• ETFs are comparatively better than mutual funds when it comes to maximizing value because an investor in a mutual fund can only purchase or sell at the end of the day at the mutual fund's closing price. In contrast, an ETF can be bought and sold at anytime during the trading day and is continually priced throughout the day, thus allowing the user to react to adverse or beneficial market conditions on an intraday basis.
• ETFs are more tax efficient because unlike a mutual fund they don’t have to distribute gains during the year by selling portfolio holdings. The gains are taxable to all unit holders but an ETF can be sold like shares, i.e., it can be sold only when required.
• Most ETFs are index based, which means that at any point of time they hold the constituents of an index in the correct proportion; in short they replicate the index.
• ETFs are very transparent in that the portfolios are always public knowledge.
• ETF fees and other charges vary from 0.1 percent to 1.0 percent of assets whereas mutual funds average anywhere in costs between 2percent and 3 percent of assets.
• People can also invest in commodities like gold. Gold ETFs, like their index based counterparts, derive their value from the price of gold. It allows investment in gold without actually taking physical delivery.
One problem associated with investing in ETFs is that of speculation - like any common stock, ETFs are subject to the laws of supply and demand. Also, unlike common stock they do not allow people to reinvest dividend of underlying securities.
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This article was contributed by Heather Johnson, who is a regular writer on the subject of instant credit card approval. She welcomes your questions, comments and writing job opportunities at heatherjohnson2323 at gmail dot com.
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