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Course 403
Exchange-Traded Funds

Introduction

Traditional open-end mutual funds have long been the staple of many investors' portfolios. Recently, however, an alternative has emerged--exchange-traded funds. While ETFs have been around since the early 1990s, their popularity has soared in recent years, and they are being used by more and more brokers and financial advisors. In addition, ETFs are popping up in company retirement plans.

ETFs, like conventional mutual funds, hold a basket of securities (stocks or bonds). The primary difference is how the investor buys and sells his or her shares. Whereas investors in conventional mutual funds buy their shares from a fund company and sell them back to the fund shop when they want to redeem, investors buying or selling ETF shares must trade with other investors in the market, much as they would do if they want to buy or sell shares of an individual stock. For that reason, individual investors must use a broker when they want to buy and sell ETF shares.

As the name suggests, exchange-traded funds are priced and traded on an exchange (AMEX, NYSE, or Nasdaq) throughout the day just like stocks. In contrast, traditional mutual funds' prices are set once a day (usually 4 p.m. Eastern) and investors must place their orders before that time in order to get that day's price. Also unlike mutual funds, you can do just about anything with ETF shares that you can with a stock, including setting market and limit orders, shorting, and buying on margin.

So, how do you tell whether an ETF or a conventional mutual fund is best for you? Here are some things to consider:

What You Want to Invest In

ETF providers have increasingly aimed to provide funds for investors looking to invest in a narrow market segment. The ETF universe is flush with funds that focus on a single market sector, industry, or geographic region. Say you favor indexing and want to own a specific corner of the market such as biotech. There may not be many index mutual funds that track those sectors--but there are ETFs that do. Also, there are many more ETFs than funds that track single foreign countries. Exchange-traded funds offer investors a way to invest in a corner of the market without having to load up on just one or two individual stocks (plus, it's more cost-efficient in terms of brokerage commissions).

However, it's also worth noting that narrowly focused funds--whether ETFs or conventional offerings--can be too hot to handle for many investors. That's because investors are often inclined to buy and sell narrowly focused funds at inopportune times.

Taxes

ETFs are also structured to shield investors from capital gains better than conventional funds. Most ETFs are index funds, so they typically trade less than most actively managed funds and should generate fewer taxable capital gains. Also, because most investors buy and sell ETF shares with other investors on an exchange, the ETF manager doesn't have to worry about selling holdings--thereby triggering capital gains--to meet investor redemptions. Moreover, because the big institutions can make share redemptions "in-kind" (rather than redeem shares for cash, the ETF gives the institution a basket of stocks equal in value to the share redemption), ETFs can unload their lowest-cost-basis stocks in the portfolio, thereby reducing their capital gains exposure.

Costs

Because ETFs don't have to manage hundreds of customer accounts or staff call centers, they have lower overhead charges that translate into lower expense ratios. However, you will pay brokerage commissions to buy and sell ETF shares, and the costs of rapid--or even occasional--trading can more than offset the initial advantage of an ETF's lower expense ratio. For those reasons, an ETF will be the most cost-effective choice for those who use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term. For others, an exchange-traded fund may not have a big cost advantage over a plain-vanilla, low-cost index fund.

Using ETFs for Portfolio Construction

Asset allocation is one of the most important decisions that you make as an investor. Having the right mix of stocks, bonds, cash, and commodities in your portfolio, and being well diversified within each asset class, can have a profound impact of your returns. ETFs can be an easy way to gain this diversification. They can be cheap, flexible, and tax-efficient and may help you gain access to sectors and asset classes that would otherwise be closed off to individual investors.

For core stock exposure, many investors could be well served by ETFs. There are several inexpensive, broad market ETFs that track major large-cap indexes, like the S&P 500. This can be a very cheap way to gain exposure to the broad market, but investors who are dollar-cost averaging (regularly investing small amounts over time) should carefully watch broker fees that may be incurred when buying ETFs, as they may push the overall costs of the investment over that of a traditional index mutual fund.

ETFs can also help you gain outsized exposure to undervalued areas of the market. Oftentimes, the short-term gyrations of the market leave certain sectors and subsectors trading for less than their intrinsic worth. Another important role that ETFs can play in your portfolio is to provide access to alternative asset classes like commodities and currencies. These areas, which used to be available only to institutional investors and high-net worth individuals, can help further diversify your portfolio. Although most investors would want these asset classes to represent only a tiny fraction of their overall holdings, their presence in a portfolio can be helpful because they can be uncorrelated to broader stock market returns.

Quiz 403
There is only one correct answer to each question.

1 Which statement below is true?
a. Exchange-traded funds offer investors a way to invest in a corner of the market without having to load up on just one or two individual stocks
b. Mutual funds offer investors a way to invest in a corner of the market without having to load up on just one or two individual stocks
c. Neither exchange-traded funds nor mutual funds offer investors a way to invest in a corner of the market – you need to invest in individual stocks to do that
2 Which investment vehicle is structured to shield investors better from taxes?
a. Mutual funds
b. Exchange-traded funds
c. Both vehicles have the same structure
3 ETFs are a cost-effective choice for investors who
a. have small dollar amounts to invest
b. trade frequently
c. use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term
4 Can ETFs be good choices for investors who want are looking for core stock exposure?
a. Yes, because there are several inexpensive, broad market ETFs that track major large-cap indexes
b. No, because there are not many ETFs tracking the broad market – ETFs focus on sectors and small markets
c. No, because ETFs are more expensive than mutual funds
5 Commodity or currency ETFs
a. Should be core holdings for all investors
b. Can provide diversification to a portfolio in small doses
c. Should play no role in portfolio construction
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