ETF Basics
March 26th, 2009. Published under Financing. No Comments.
While many investors have an overall outlook, and may be able to accurately predict what will be the next big thing, it is often harder to nail which company will be able to best take advantage of the coming conditions. After all, while it may be easy to figure out, retail stocks are going to be hammered by this recession, that doesn’t help you decide which retail company is best to short. And while it may be easy to figure out, reduced demand from the developed world is going to hurt Chinese companies, its much harder ” especially for those non-mandarin speaking people such as myself ” to figure out exactly which Chinese companies might escape this fate. So how can we take advantage of these outlooks without having to pick specific companies?
ETF. The latest all important acronym to add to your vocabulary. ETF stands for exchange traded fund; a relatively recent innovation that allows investors to directly target sectors for investment, instead of picking individual stocks, and praying those stocks wont underperform their sector. ETFs are similar to mutual funds, with a couple important differences. They can be bought and sold like a stock, no minimum investment or redemption fees, and you can short them.
Each ETF is designed to mimic an investment in a certain industry, region, or type of stock. Some examples of ETFs are the XLI, XLU, and EWC. These ETFs grant an investor exposure to the industrial sector of the S&P 500, the utilities sector of the S&P 500, and the entire Canadian stock market, respectively. Similarly, one who simply wanted to match the S&P 500 indexs returns could just invest in the SPY.
But why shun the mutual fund? Why take the new guy over the established king? Lets start with the tax advantage. When mutual funds endure large sell offs, they have to liquidate many positions, some of which are currently at a gain. They then have to pay capital gains on those positions, and this negatively impacts their return. It would be an understatement to say that Mutual funds generally have higher expense ratios in general compared to ETFs. It can sometimes cost as little as 8 dollars to get into an ETF whereas a mutual fund of 20,000 that grows to 60,000 over a 20 year period may have conservatively lost as much as 18,000 to its competent managers.
Perhaps the biggest consideration is the simple convenience of owning ETFs when compared to mutual funds. They can be bought and sold (or shorted) any time during the trading day, using the same order types available to normal stocks. Free from redemption fees, the only deterrent from actively trading an ETF is belief in the efficient market hypothesis, and the standard commission costs from buying and selling stocks
Another important consideration is that most of the more liquid ETFs are optionable. This means that option-savvy investors can harness the power of stock options to change the risk-reward profile of their positions, and risk-conscious investors can use stratagems such as the covered call and protective put to protect their investment.
There are some disadvantages to ETFs as well. Some ETFs have complex structures that can lead them to deviate from what they are supposed to be tracking. A similar instrument, ETNs, can also easily be mistaken for an ETF, leading to some general confusion about what exactly you are investing in. Yet for those willing to put in the work to learn, ETFs can be a highly profitable venture for the modern day portfolio.
The only reason not to use ETFs is a lack of understanding, for they really are one of the most revolutionary investment tools of the 21st century. Their ability to reduce risk through diversification across an asset class, while still effectively giving an investor exposure to an entire sector, should be taken advantage of by everybody, for both long and short plays. ETFs are an invaluable asset for everyone invested in any stock market, and their advantages should be used to the fullest.