How Exchange Traded Funds Work - Part II

Benefits of Exchange Traded Funds

There are several benefits to exchange traded funds over traditional investments, such as mutual funds. Here are some benefits of ETFs:

Advantage Over Stocks

ETFs trade like stock but are structured somewhat like mutual funds. While mutual funds are priced at the end of the day (NAV), exchange traded funds prices fluctuate like stocks throughout the day.

The exchange funds can be held long-term but also provide opportunity for speculative investors to bet on shorter-term market movements. For example, if an investor sees a steep rise in the S&P 500, he can purchase a SPDR, hold it till its price increases and sell it for profit before close of market trading. Meanwhile, investors holding mutual funds that mirror the S&P 500 are not able to leverage daily fluctuations.

Unlike mutual funds, exchange traded funds can be used for speculative trading strategies, such as margin trading and short selling. In essence, an ETF offers the investors an opportunity to trade the entire market as it were a singular common stock.

Diversification

Exchange traded funds are perfect for creating diversified portfolios. There are several hundred ETFs available which cover every major index, such as Nasdaq, S&P, and Dow Jones. The ETFs cover every sector of the market, including large caps, small caps, growth, value, etc. Additionally, ETFs cover international, regional ETFs (Latin America, emerging markets, Pacific Rim), and country-specific (India, China, Brazil, Australia) arenas. Also ETFs cover specialized and specific industries (financial, energy, technology) and market niches (gold, REITs).

Other options available for ETF investors are different asset classes, including fixed income. Herein, an investor with the purchase of exchange traded funds can diversify their portfolios that can meet the requirements of any asset allocation model.

Low Expense Ratios

ETFs are cost-effective investment instruments. They provide benefits of index funds, such as broad diversification and low turnover. ETFs cost less than index funds.

Exchange traded funds also cost a lot less than mutual funds in expense ratios. For example, most ETFs have basis points of 10 to 30 while comparable mutual funds may be 100 basis or more.

These instruments are purchased through brokerage houses that incur a commission charge. You have to be careful in your ETF investment strategy as not to negate the value of the low expense ratio with a trade commission.

Tax Efficiency

Exchange traded funds are now becoming popular among tax-conscience investors. The portfolios of investors containing ETFs are more tax efficient than investors holding mutual funds. The unique composition of ETFs enable large volume trades, the ability to receive in-kind redemptions.

Redemptions permit the investors to redeem the ETFs for the shares of stocks that the ETFs track. This permits the investor to defer tax liability until the investment is sold. Additionally, you have the choice of picking ETFs that don’t have huge capital gains distributions or pay dividends

Disadvantages to Exchange Traded Funds

Although there are many advantages to ETFs but like other investments has its disadvantages.

Brokerage Costs

The exchange traded funds have low expense ratios which may be negated by excessive brokerage commissions. Every time a trade is performed, a buy or sell, commission is charged to. The commission structure works similar to the buying and selling of common stocks.

Trading broker commissions make ETFs unattractive investments vehicles for dollar cost averaging when investing small amounts. It would be preferable to invest in a no-load mutual fund that tracks an index like the S&P 500 which is a more cost-effective option.

Market Price

Another small flaw in ETFs is that it is traded not at Net Asset Value (NAV) as are mutual funds. ETF trading is similar to trading of stocks on the exchanges; supply and demand forces influence ETFs market prices above and below the true value of the underlying assets.

Dividend Reinvestment Plans

Exchange trade funds, unlike open-ended mutual funds, do not allow reinvestment of dividends.

Odd Lots

You can trade exchange traded funds in odd lots, sometimes. Well, you can buy round lots or odd lots, but some ETFs may not permit odd lot trades. Merrill Lynch HLDRs are registered in a different manner than other ETF’s, hence have restrictions of trades in round lots only.

Conclusion

It is easy to understand the popularity of ETFs. The accompanying costs of ownership are low, offer immense choice and flexibility in investment areas, and are tax efficient. Since the ETFs inception in 1993, the expansion of these investment instruments has seen a great rise.