Exchange traded funds offer individual investors:
- Advantages of stocks and mutual funds combined
- Lower fees** (ordinary brokerage commissions apply)
- Lower capital gains taxes**
Recently, these exceptional features and benefits have helped exchange traded funds explode in popularity and emerge as one of the most flexible, multi-purpose investment vehicles available.
Ever since the American Stock Exchange championed and pioneered the concept of a tradable basket of stocks with the creation of the Standard & Poor’s Depositary Receipt (SPDR) in 1993, exchange traded funds have evolved into a completely new investment category.
Today, the number of ETFs listed and traded at the Amex has grown to more than 180 and continues to growâ€”not only in the number of products and their varietyâ€”but also in terms of assets and market value.
What are exchange traded funds?
Exchange traded funds (ETFs) are index funds or trusts* that are listed on an exchange and can be traded intraday. Investors can buy or sell shares in the collective performance of an entire portfolio as a single security. Exchange traded funds add the flexibility, ease, and liquidity of stock trading to the benefits of traditional index fund investing.
The American Stock Exchange lists ETFs on more than 180 broad stock market, stock industry sector, international stock, U.S. Treasury, and corporate bond indexes and commodities, providing a vast selection of investment opportunities. ETFs provide a simple and effective way to invest in markets all over the world. Investors can set long-term investments in the market performance of the top companies in the top industries within the United States or abroad, or customize asset allocations using diversified investments in stocks in particular industries or countries or in U.S. bonds or commodities.
The advantages of ETFs:
ETFs, like index funds, offer greater tax benefits because they create fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading.
Because of this particular structure, ETFs are not required to sell securities to meet investor cash redemptions, potentially generating capital gains tax liability for remaining investors. Keep in mind that the sale of an ETF will generate capital gains/losses for the investor liquidating shares.
Expenses can have a masive impact on returns for investors. ETFs usually have a notoriously lower annual expense ratio than other investment products. ETFs are less likely to experience high management fees because they are index-based, not “actively” managed.
Since they trade on an exchange, ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. An investor selling ETF shares may realize capital gains or losses, as with common stocks. Purchases or sales of exchange traded funds are subject to brokerage commissions.
ETFs are usually designed to match the performance of their underlying index or commodity.
Buying and selling flexibility
because they are exchange traded, ETFs can be:
- Bought and sold at intraday market prices
- Purchased on margin
- Sold short
- Traded using stop orders and limit orders, which help investors to specify the price points at which they are willing to trade
All day tracking and trading
ETFs are priced and traded throughout the day, and are not restricted to once-a-day trading at the end of the day.
Due to the pricing of ETFs is continuous during trading hours, investors will always be able to obtain updated share prices from their broker or financial adviser.
since each ETF is comprised of a basket of securities, it inherently provides diversification across an entire index. Also, the expanding possibilities of ETFs available at the American Stock Exchange offer exposure to a diverse variety of markets, including:
- Broad-based equity indexes (i.e.: as total market, large-cap growth, and small-cap value)
- Broad-based international and country-specific equity indexes (i.e.: Europe, EAFE, and Japan)
- Industry sector-specific equity indexes (i.e.: healthcare, energy, and real estate)
- U.S. bond indexes (i.e.: long-term Treasury bonds and corporate bonds)
- Commodities (i.e.: gold, silver, and oil)
Dividends paid by companies and interest paid on bonds held in an ETF are distributed to ETF holders, less expenses, on a pro rata basis.
However, not all companies will pay dividends. Based on past performance, few distributions can be expected from certain ETFs. There may also be opportunities for reinvestment of distributions.
Wide array of investment strategies
Investors can benefit from the convenience and flexibility of ETFs to pursue a vast array of investment strategies.
Core investment Investors can use ETFs as a core investment for their portfolio. The purchase of shares in a single ETF can provide broad market exposure for long-term holding that is simple to establish, easy to track, inexpensive, and tax efficient.
Portfolio diversification ETFs cover virtually every segment of the equity market and several segments of the U.S. bond market and commodities, providing an easy and convenient way to adjust the investment mix of a core portfolio.
Hedging Exchange traded funds can be purchased on margin and sold short, which has opened up risk management strategies for individual investors that were available just for large institutions. For example, ETFs can be sold short to hedge a core stock portfolio or interest rate fluctuations. This allows investors to keep their portfolio intact while protecting them from market losses.
In a declining stock market or rising interest rate environment, profits from a short position can offset some of the losses in a portfolio. (Investors are required to make arrangements to borrow securities before selling short.) Listed options, available on some ETFs, also offer chances for additional hedging or to increase income. Investors should contact their broker regarding initial and maintenance margin requirements.
Cash management ETFs have often been used to “equitize” cash, providing a way for investors to put cash to work in the market or maintain allocation targets while determining where to invest for the longer term.
Rebalancing Investors can adjust ETF positions whenever they need to throughout the trading day, without redemption fees or short-term restrictions. Usual brokerage commissions will apply.
Tax loss strategy An investor can sell a security that is underperforming and claim a tax loss but retain exposure to its sector by investing in an ETF. It is recommended to consult a tax advisor about a tax loss strategy.
Risks and other considerations
ETF shareholders are subject to risks similar to those of holders of other diversified portfolios. A basic consideration is that the general level of securities or commodities may decline, affecting the value of an exchange traded fund because ETFs represent interest in securities or commodities.
When interest rates rise, bond prices will probably decline, affecting adversely the value of fixed income ETFs. Moreover, the overall depth and liquidity of the secondary market may also fluctuate.
An exchange traded sector fund may also be adversely affected by the performance of that specific sector or group of industries on which it is based.
International investments may involve risk of capital loss from unfavorable fluctuations in currency values, differences in generally accepted accounting principles, or economic, political instability in other nations.
Although exchange traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes or commodities, the trusts may not be able to exactly replicate that performance because of trust expenses and other factors.
* iShares COMEX Gold Trust, iShares Silver Trust, and United States Oil Fund are not index funds or diversified baskets of securities. ProShares seek performance that corresponds to a multiple, inverse, or inverse multiple of an index.
** ProShares Trust portfolios will experience high levels of portfolio turnover, which will increase transaction expenses and may be more likely to generate taxable short-term capital gains than other ETFs.