Why invest in Exchange Traded Funds?
Like mutual funds, ETFs give you direct diversification. ETFs are a basket of securities that typically track a specific market index.
Until now, ETFs were principally index funds (fund that tracks a specific index). Today, we see the emergence of active ETFs. Because ETFs are more efficient than mutual funds, ETF are set to replace mutual funds.
Created in 1995, ETFs have seen their asset under management (AUM) exploded. At the end of 2010, the AUM represents $1.45 Trillions. According to McKinsey & Co, ETF assets could more than double to $4.7 trillions by 2015.
An ETF (Exchange traded fund) is like a mutual fund that you can buy and sell on a securities exchange. Like a mutual fund, you should check if the ETF’s price trades close to the NAV. The NAV (net asset Value) represents the ETF real value.
-Most ETFs do not have 12b-1 fees (load fees). Expense ratios are usually lower than Mutual funds. Between 0.25% and 0.7% against up to 2% for mutual funds.
-No investment minimum, contrary to mutual funds.
-You can use option on ETF, use all trading techniques, including limit orders and stop loss orders.
-With an ETF, you can short the market or invest with leverage.
-Lower taxes because of less turnover.
-You pay capital taxes only when you sell your shares for a profit.
-ETFs can be traded all day long.
-ETFs are more transparent; you have access to the portfolio.
-With an ETF you can bet on a particular sector or industry.
ETFs are generally for long-term investors. The transaction fees are generally higher for Exchange Traded Funds.
Anyway, with the ETF future development, the transaction fees should be lower.
A quick overview of ETFs major providers.
The major ETF providers are Ishares, Powershares, Proshares, SPDR and Lyxor.
Ishares ETFs were started by Barclays and Morgan Stanley. Ishares were sold to Blackrock in 2009. Ishares represents more than 180 ETFs.
Powershares (Invesco) was created in 2003 and has more than 120 ETFs
Proshares are specialized in short and leveraged funds. Proshares offers more than 124 ETFs.
SPDR (S&P Depositary Receipts) is part of State Street Global advisor, n°2 ETF Manager according to Pensions & Investments (27 June 2011).
-You pay capital taxes only when you sell your shares for a profit.
Lyxor ETF has more than 175 ETFs. Lyxor is the number one ETF provider in Europe and Asia according to Risk Magazine.
ETF permits all sorts of strategies:
If you want to bet on a particular industry or sector, you can do it thanks to ETFs. For example, you can invest in the banking industry or in the Healthcare sector.
» Commodities like oil or gold
Before the creation of ETFs, it was difficult for individual investors to invest directly in commodities. Now you can invest in agricultural commodities, metals, oil, gas and precious metals.
» International markets
Thanks to ETFs, you can now invest easily in a foreign market. For example, it is very difficult for a foreign investor to invest directly in the Chinese booming economy. With an ETF, you can invest in various Chinese indexes.
Investing in bonds requires lot money. For example, some bonds are sold at $50’000 a piece. So for an individual investor, it will require a considerable sum in order to create a diversified bond portfolio. An ETF permits to invest in bonds, in various strategies related to fixed income investments (Corporate bonds, high yield bonds and international bonds to name a few).
If you are an individual investor and you want to invest in currencies, you must open a Forex account. Thanks to ETFs you can invest in currencies with you regular broker account.
» Small, medium and large cap
If you believe small companies are better investments than large capitalization companies, you can invest in ETFs tracking small capitalization indexes.
» Short the market
If you think that the stock market will fall, you can place this can of bet thanks to ETFs.
» Invest with leverage
With ETFs, you can invest more aggressively with leverage up to 3. You can invest in any kind of securities with leverage (equities, bonds, commodities, real estate). Leveraged products are risky investments, if your bet is correct it can help you to multiply your gains but if you are wrong you will also multiply your losses.
» Invest in Hedge fund strategies.
Recently some ETFs have been created to track certain hedge funds strategies. Thanks to this new support, hedge funds strategies are not reserved anymore to professional or rich clients.
So far, we have talked about the advantages of Exchange traded funds. Unfortunately, ETFs have also some drawbacks.
During the ultimate years, the number of failed launches has dramatically risen. When investing in ETFs, you should always look at the liquidity of the funds. If the fund is not liquid enough, you will pay a big spread on your subscription or redemption.
Beware to synthetic ETFs:
Contrary to regular ETFs, synthetics ETFs don’t generate investor returns by holding a correspondent basket of stocks. They generally enter into an asset swap (a counter party replicate some kind of securities index).In general, synthetic ETFs are more common in Europe.
Furthermore, the ETF provider, often a bank, must back the ETF with a basket of securities. This basket of securities represents a collateral in case something go wrong. The problem is that the collateral doesn’t need to match exactly the tracked index. Usually, the corresponding collateral is composed of less-liquid investment such as unrated corporate bonds and small-business loans.
Before investing, it is highly important reading the corresponding prospectus to see if the ETF is backed by equivalent securities or if it is constructed through some asset swaps. Don’t get me wrong, in the short time, synthetic ETFs are fine. But in case of another systemic crisis, your ETF can be worthless if the asset swap counter party default.
According to a letter to European regulators from the CFA Institute, an association of investment analysts, "there is an incentive for banks to sell synthetic ETFs through their asset management branches in order to raise funding against illiquid portfolios of securities which could not otherwise be financed in the repo market, or at a significant haircut."
A note on Exchange traded notes
ETNs are senior, unsecured debt securities issued by a financial company generally a bank. Whereas ETFs are typically registered investment companies and are collateralized by an underlying portfolio of securities.
ETN can be more risky than ETF because the principal is not guaranteed and the ETN value can be affected by the rating of the issuer.
I hope this ETF guide answers your questions about Exchange traded funds.
If you want to further this ETF guide, you will find below some usefull links.
ETF Trends provides articles, tools and education on ETFs.
ETFDB is a website proposing a large ETF screener.