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Getting Started with ETFs
Conceived more than 80 years ago and now owned by 91 million
individuals from 54 million households in the U.S., mutual funds
owe their strong appeal to a combination of features:
professional management, instant diversification for low minimum
investments, prices based on net asset value (NAV) and marked to
market daily, and easy reinvestment of dividends and capital
gains.
Known legally as open-end investment companies, they issue
new shares when investors want to buy them at NAV per share
plus
sales charges unless they are no-load funds but they must redeem
shares at NAV (less sales charges unless they are no-load funds)
when holders want to sell.
These characteristics have long distinguished mutual funds
from a second type of investment company, closed-end funds,
whose issued shares are fixed at creation. This means that
bid-and-ask prices may be above or below NAVs.
The third type of investment company is a Unit Investment
Trust, which is a fixed basket of stocks (not an evolving
index) held for a pre-determined time.
If mutual funds have been found by some to be lacking a
feature, it often has been the opportunity to buy or sell their
shares at any time when markets are open at known prices
just
like publicly traded stocks, bonds, and closed-end investment
companies.
Exchange-traded "equity" funds (ETFs) were
introduced in 1993 by a subsidiary of the American Stock
Exchange. They are designed to give investors a vehicle that
resembles mutual funds but also provides the opportunity to have
buy or sell orders promptly executed at known prices on a
securities exchange (through a broker) whenever markets are
open.
Named the SPDR Trust, whose shares were referred to as
"Spider" (for SPDR, or Standard & Poor's Depositary
Receipt), the first ETF was formed as a UIT with the investment
objective of tracking the S&P 500 Index, thereby permitting
its portfolio to be changed when S&P changed the composition
of its index.
Its investment policies thus were similar to those of the
mutual funds that had been passively managed to match the
performance of the S&P 500, beginning with Vanguard 500 in
1976, or other domestic and foreign stock and bond price
indices.
Over the next three years, three more ETFs, organized as UITs,
followed the SPDR model, matching the following underlying stock
indices, the S&P MidCap 400, the Dow Jones Industrial
Average, and the NASDAQ 100. By 1996, a major change occurred
when the first two ETFs organized as open-end investment
companies were introduced.
ETFs have experienced phenomenal growth. By the end of 2005,
ETF total assets had reached $296 billion. Some 193 ETFs were
organized as open-end funds, representing 68 percent of total
ETF assets and eight were organized as UITs, representing 32
percent. At the time, as much as 63 percent of ETF assets were
broadly diversified across domestic equity sectors while 10
percent were concentrated in individual market sectors or
industries. Another 22 percent of ETF assets were invested
internationally; the remaining 5 percent, in bonds.
Why have ETFs been so successful in attracting investors?
1. Whatever their investment characteristics, the offer of
professionally managed portfolios resembles mutual funds
whether
invested in diversified or concentrated pools of domestic or
foreign stocks and bonds.
2. The cost of ETFs is much-debated, but many financial
planners tend to agree these vehicles can be cost-effective when
used correctly. For instance, shares of ETFs structured like
index funds may have even lower annual expenses than index
mutual funds, which, in turn, tend to be lower than those of
actively managed, low-cost mutual funds. ETFs must, however, be
bought and sold through brokers and those trades do involve
sales commissions. Of note, some financial planners say ETFs
tend to be a good vehicle to use when a large amount of new cash
comes into an account. But, due to commission charges, ETFs are
not recommended for people with small accounts or those that are
dollar cost averaging.
3. ETFs are transparent investments. Unlike traditional
mutual funds, ETF holdings are fully transparent. Investors know
what holdings are in the ETF at any given time. Each ETF also
has a NAV tracking symbol for even more precise analysis. This
helps keep ETFs trading within pennies of their intra-day NAV.
4. Taxes may be managed. While well-managed index mutual
funds may distribute less in taxable capital gains than actively
managed funds, the SEC's 2001 release noted that "the ETF
structure may allow an ETF to avoid capital gains to an even
greater extent
"
"This is a really big deal for taxable accounts - it is
almost an unfair competitive advantage for ETFs," said one
financial planner member of the Financial Planning Association.
Many ETFs have not distributed any long- or short-term
capital gains in five years or more and if they have, the
distributions are very tiny. Financial planners also note that
because ETFs trade like stocks, an investor is able to control
the tax treatment of an investment. By holding an ETF for at
least one year and a day, capital gains will be treated as
long-term capital gains which are currently taxed at 15 percent
(10 percent for low tax bracket investors.)
5. Trading flexibility the ability to buy and sell ETF shares
any time during the trading day and at a known price that index
mutual funds cannot provide. Unlike mutual funds, ETFs can be
bought on margin or sold short, the normal up-tick rule when
shorting ETFs is not applicable.
June 2006 This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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