Exchange-traded Funds:A Good Investment Option
Mar 23rd, 2008 by Kaushik Adhikary
Image via WikipediaETFs (exchange-traded funds) in the investment world are the latest and greatest. Though these funds are buzzing around for more than ten years, ETFs gain momentum in recent years.
ETFs are a group of stocks that trade on the stock exchanges as a lot. They have tracked a particular index in the past such as the Dow Jones Industrial Average or the NASDAQ-100. In recent times ETFs have certain characteristics in common, with a strategy of investing in certain regional or sectoral markets having certain market capitalization.
You may find mutual fund investing more advantageous. But ETFs have many advantages over open-ended and closed-ended mutual funds. Buying ETFs are low cost business since you are paying a commission/brokerage just like an individual stock. ETF’s ongoing maintenance fees are cheaper than actively managed mutual funds, or index mutual funds.
Because ETFs trade like stock they have liquidity. With a simple phone call you can buy or sell. ETFs are priced every 15 seconds and trade continually throughout the day. This is different from mutual funds that are only bought and sold at the end of the trading day. ETFs can be easily traded since these are held in a brokerage account.
Index and actively managed funds put aside a portion of their investable assets in cash. This cash is used to pay someone who is selling their fund. There is no need to retain a portion of cash for ETFs since these trade like individual stocks on the open market.
In an actively managed mutual fund, the fund largely been invested in large cap, but sometime may end up investing in small or mid caps. ETFs are required to maintain a 99% correlation with the index or basket of stocks that it represents.
Because ETFs trade like individual stocks you have the additional features of stock. ETFs can be sold short or on margin. They can have limit buy and stop loss orders for buying and selling. Put and call options can be purchased and sold using ETFs.
There are of course many disadvantages to ETFs as well. They are not an appropriate investment to use with dollar cost averaging. If you have to pay a $10.00 fee each month when you make that $50 or $100 investment it can be difficult to make up that fee.
With the explosion of ETFs you have to watch out what the fund is using as its underlying stocks. Sometimes it can be such a narrow focus that you really are not achieving diversification.
Due to the ease of trading you can get caught up in riskier strategies than you want. Short term trading and market timing can result in significant losses. Buying and selling ETF puts and calls or buying on margin is speculating and is riskier than buying and holding.
ETFs make sense under the right circumstances. You can use a broad index ETF as a core holding. This can be supplemented with targeted ETFs to provide weighting in a particular sector, region or type of market capitalization. As always know what you are investing in and be sure that it fits into your portfolio.
