Exchange Traded Funds 101 – a simple introduction
With an increasing educated population, particularly in personal finance and investing area, people are more likely to take charge of their financial affairs themselves rather than leave everything and blindly listen to financial advisers. As exchange traded funds is one essential investment vehicle for the masses, there is a need to provide a good introduction on it.
This blog post will touch on this type of product from several different aspects, including costs, size of markets that ETFs tracked, trading details, and tax considerations.
Exchange traded funds is without doubt, a very cost effective tool for constructing a well diversified portfolio of stocks. ETFs is very similar to its older relative – the index fund in the sense that both are low cost and both only seeks to duplicate the performance of an index. The more new versions of ETFs got hold a basket of stocks that contain certain attributes like dividend yields above a certain percentage but they are nevertheless, still passively managed with much lower costs than active managed funds by first class honour fund managers.
The ETF achieve the effect of matching the performance of an index by holding financial assets like stocks or bonds in the same percentage as the underlying index itself. For instance, if the index contains 5% of General Electric, that the ETF attempting to track that index will also have 5% of its assets in General Electric stocks.
ETFs differ from traditional mutual funds in at least 4 ways,
1. Degree of transparency
While an index fund also have total transparency, the same cannot be said of actively managed mutual funds. This is simply to prevent rival mutual fund companies from mindlessly copying the investment strategies of truly top performing fund managers. This is like Warren Buffett only announces to public after his acquisitions of stocks in a particular company is complete as people will simply jack up the prices if he tell the whole world before starting to acquire substantial stakes as almost everyone knows his track record in picking stocks. But traditional mutual funds do reveal fund holdings at regular time intervals to comply with some regulations.
2. Ways of trading
ETFs are like stocks, and traded like stocks, their prices change throughout the whole trading day while index and mutual funds prices are only based on the net asset value of that fund at the end of that trading day. To further elaborate, it does not matter when you placed an order for a mutual fund during the day, the price you paid when buying and you get when selling is that day closing price. This is in sharp contrast to ETFs where you can get different prices depending on when you placed the order during the day. However, this should not be an issue for long term investors as opposed to short term traders.
3. ETFs can use leverage to invest while traditional mutual funds cannot
ETFs are listed on the stock exchanges like stocks, hence they can be traded freely like stocks and all the things that can be done with stocks can also be done with ETFs. As a result, one can short or engage in contra trading on ETFs. However, this is not recommended for the great majority of people as other than losing money in the long run, you also have to spend your life doing meaningless things like watching the changes in stock tickers values on a computer screen. Other than leverage, one can also employ different types of orders like market or limit.
4. No sales and load charges on ETFs but got brokerage commissions and vice versa for traditional mutual funds
As ETFs are traded like stocks, there is no sales charge to speak of but of course there are brokerage commissions to be paid when you buy and sell. As a result, whether it is more cost effective to invest in an index through index fund or a corresponding ETF depends on the size of capital for your case.
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