Investing 101: Exchange-Traded Funds

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Two issues concern even the most devoted mutual fund fans: fees and control. An array of various fees and fee structures makes it difficult for fund investors to compare funds in terms of cost. And you have no way of knowing in advance how expertly management decides where to invest your money.

The ETF solution

Both of these concerns are partially resolved with the exchange-traded fund, or ETF. ETFs invest in “baskets of securities” identified in advance. They generally track an index, such as the S&P 500 or Wilshire 5000, for example, but also indexes that are industry-specific (real estate or retail) or specific to a certain country or region. ETFs can also invest in commodities (gold or silver), a diversified grouping of commodities, or currencies. Dozens of new ETFs are launched each year.

Because the stocks making up an ETFs are determined in advance, you do not need to pay large fees for the management of an ever-changing portfolio. You don’t have to make (or delegate) investment decisions, either, because everything in that basket is known beforehand.

Another advantage of ETFs is trading convenience. Traditional mutual funds trade directly with management, and their valuation is based on net asset value (NAV) at the close of the trading day. This is cumbersome and often poorly timed because NAV can change within a matter of hours in a volatile market. The ETF trades on the public exchanges just like shares of stock, meaning you can track the value of the basket of stocks by the minute instead of by the day.

The downsides

As versatile and convenient as ETF are, they also have potential downsides. One is that the basket of securities is subject to the same market risks as all securities. If a specific sector underperforms and you happen to own an ETF that focuses on that sector, you will have to watch the value of your portfolio decline.

Another downside: a sector ETF will yield an overall return equal to the average of performance among all of its components. That means that the over-performers are averaged with under-performers. Some investors would prefer to identify a sector’s clear leaders and buy shares of that company, rather than settling for the average.

Finally, ETF shares can be easily and conveniently traded. However, if you want a truly diversified portfolio, you will need to buy shares in several industries and among securities that do not have a common feature (such as operating in the same industry).

In deciding between an ETF and a traditional fund, compare costs and fees as well as past performance.

The bottom line

If you need to decide between an ETF and direct purchase of shares, consider the pros and cons of isolating your choice to the strongest companies in a sector — that is, assuming that you have the time, ability and willingness to research and identify those companies.

ETFs are an excellent choice for those unsure of how to pick a stock, but who want to invest in a specific industry. In that case, make sure your overall portfolio is well diversified and you don’t end up putting all your eggs in one basket – even if that is a basket of stocks spanning a whole sector.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Investing 101: Exchange-Traded Funds was provided by Minyanville.com.