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There’s been a lot of recent talk in the financial press about
exchange traded funds, or ETFs. Some of you may already be
familiar with them, but my guess is for most individual
investors, the term “exchange traded fund” is just another bunch
of financial gibberish – vaguely familiar but completely
meaningless. Well, to artlessly coin a phrase from the movie
Braveheart, “we’ll ‘ave to remedy that then, won’t we.”
In financial-speak, ETFs are hybrid investment vehicles that
combine the trading flexibility of individual stocks with the
diversification benefits of mutual funds. ETFs possess
characteristics that make them particularly suited for investors
who want a low-cost way to obtain broad exposure to specific
sectors of the financial markets.
That’s mouthful, but what it really means is that ETFs are like
mutual funds, only better. And they are better for several
reasons.
First, ETFs are cheaper than mutual funds. ETFs have extremely
low annual expenses, often less than 20 basis points (0.2%).
Contrast this with actively managed mutual funds whose disclosed
expenses average over 135 basis points (1.35%) – and this
doesn’t even include the additional 2% to 5% in loads, 12(b)-1
marketing fees, transactions costs, and soft dollar expenses
mutual funds charge you but never disclose (except in the
teeny-weenie small print nobody ever reads).
Second, ETFs have a lower turnover than most mutual funds.
Because ETFs are passively managed and consist of a fairly
static basket of stocks, they generally have little or no
portfolio turnover. Contrast this with many actively managed
mutual funds that can turn their portfolio over several times
during the course of a year – incurring transaction fees on each
purchase and sale. Third, ETFs are more tax-efficient than
mutual funds. Unlike actively managed mutual funds, which
annually spin off taxable short-term gains and distributions to
shareholders, ETFs ordinarily only generate taxable capital
gains when you sell them. Moreover, due to their unique legal
structure, ETFs are also more tax-efficient than their passively
managed index mutual fund counterparts. Fourth, ETFs give you
more flexibility than mutual funds. They can be bought and sold
through your broker without restriction during the trading day,
just like a traditional stock. This provides investors with
significant flexibility compared to mutual fund investors, who
cannot engage in transactions during market hours. Fifth, ETFs
allow you to more easily customize your portfolio than you can
with passively managed mutual funds. Today, there are over 150
ETFs sponsored by a variety of institutions, including
SelectSector SPDRs (State Street Global Advisors), iShares
(Barclays Global Investors), HOLDRs (Merrill Lynch), and VIPERs
(Vanguard). These ETFs focus on dozens of different market
sectors, from bonds to technology, and everything in between. As
a result, investors can mix and match them to achieve a desired
portfolio balance, emphasizing certain sectors while staying
away from others depending on the market environment. Sixth,
ETFs are more cash efficient than mutual funds. Since ETFs don’t
need to maintain a cash position to satisfy redemptions, they
can be fully invested in securities. This usually allows them to
outperform a mutual fund with a corresponding basket of
securities, but which incurs a substantial cash drag. Finally,
ETFs offer more sophisticated hedging options for experienced
investors. Because ETFs can be bought on margin or sold short
like a stock, they allow experienced investors to implement
sophisticated hedging, market-neutral, and other alternative
investment strategies. Exchange traded funds aren’t for
everyone, though. Because they are traded on stock exchanges,
you incur a brokerage commission when you purchase or sell them.
As a result, if you are making small regular contributions to
your investing account, you’ll end up being swamped in
commissions. For more information about exchange traded funds,
you can go to ETFConnect (www.etfconnect.com) or the American
Stock Exchange website (www.amex.com). Or, feel free to take a
look at my recent white paper entitled Exchange Traded Funds:
Investment And Hedging Strategies at (www.flagship-capital.com).
About the author:
David A. Twibell is president of Flagship Capital Management, an
investment advisory firm in Colorado Springs, Colorado. Flagship
provides portfolio management and wealth planning services to
individuals, corporations, and non-profit entities. For more
information, please visit www.flagship-capital.com.
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