In 2007, 270 new ETFs were launched, up from around 140 from the year before. Assets invested in ETFs grew from $420 billion to $608 billion, a nearly 50% increase in funds in just one year. These numbers alone warrant any investor worth his salt to investigate what ETFs are, what are the advantages and disadvantages of an ETF, and how to proceed investing in these relatively new products.
ETFs (Exchange Traded Funds) are baskets of securities which are traded on a stock exchange. In many ways, ETFs closely resemble mutual funds, except for the fact that an investor can exit or enter an ETF whenever the market is open. For a mutual fund, the investor must wait until the end of the day, after the market closes, to buy and sell shares directly with the mutual fund company. Keeping mutual funds in mind while considering ETFs is a reasonable framework when learning exactly what ETFs are, and what you can do with them.
ETFs are not neatly contained within one easy category. ETFs track stock market indexes (S&P, Dow Industrials), commodity prices (oil and gold), equity sectors (pharmaceuticals and semiconductors), emerging stock markets (Brazil and India) and even more complicated derivatives, like inverse market index funds and strategy-focused ETFs. In each case, the ETF is tracking the price of another asset or index; the ETF is traded totally separately from the underlying asset. When an investor purchases shares of an ETF which is composed of a basket of securities, it is important to remember the investor isn’t buying shares of the underlying securities; he’s buying shares of an ETF.
Let’s focus on what the major different types of ETFs there are in the marketplace today.
Market Index ETFs. One of the most popular ETFs, if not THE most popular ETF, is the ^SPY^, which stands for Standard & Poor’s Depository Receipts. The SPY is the ETF which tracks the S&P 500, and the share price of the SPY is reflected in the value of the S&P 500 Index.
The SPDRs was the 2nd generation of what was to become the modern ETF. One of the main reasons the SPDRs took off is also one that continues to drive its popularity today: it’s a lot cheaper to buy a share of the SPDRs than it is to buy an S&P 500 big contract or an Emini. The SPDRs provide traders with an opportunity to invest in the broad index, without needing to front thousands of dollars just to get in the trade (like the big contract or emini). The simplicity of execution and the relatively cheap price will probably keep the SPDRs and other market index ETFs front and center for years to come.
Commodity ETFs. Another popular choice among investors has become commodity ETFs. The benefits of commodity ETFs are similar to the market index ETFs, namely, that investors are provided with a chance to participate in market moves at a price not normally available. For example, a futures contract for gold would cost the trader around $400, which is basically a down payment on the investor’s bet on price movement. The streetTRACKS ^GLD^ is currently priced around $90, about 1/4 of the price of the futures downpayment. So with the commodities, ETF provide a more simple alternatives to the somewhat confusing and more expensive futures contract.
Equity Sector ETFs. It’s easiest to think of Equity Sector ETFs in terms of a sector-specific mutual fund. These are assets composed of a number of different stocks within a specific sector. The ETF allocates funds to different companies within a sector, based on proprietary formulas and specific values outlined by the company funding the ETF. An important thing to keep in mind is that the basket of stocks could be fixed, or it could rotate on a fixed basis, such as quarterly, as new stocks are rotated in and out based on the basic standards of the ETF.
Sector-specific stocks are popular because it allows traders to diversify their portfolio within a sector, without allocating too much money to just one company. An easy example is to consider the ^PPH^. Our imaginary investor, Tim Cramer, thinks that “drugs are in,” and that drug companies across the U.S. are going to double revenues over the next year, based upon superior backtesting and research. BUT, Tim Cramer’s research is not company-specific, meaning that he just knows the entire drug sector will take off, not which specific stocks. The PPH would be the perfect idea for Mr. Cramer, as he diversifies his assets within the sector. Then, once the big move starts to happen and the leading companies make themselves known, Cramer could sell his PPH shares, and get into to the stocks which are actually moving.
Emerging Market ETFs. Emerging market ETFs also had a big year in 2007, as investment commentators all over the news gushed praise upon the ^EEM^. If media popularity and timeshare were worth market value, then this fund would be priceless.
The emerging market ETFs allow investors to capitalize on massive market moves in other countries. There are a number of different ETFs in this category, some of which are country-specific, some of which are index-related, and some of which are a classic basket of foreign equities. The obvious advantage of these types of vehicles is that it’s a lot easier to get involved in a growing country’s markets, without having to learn the language, open a foreign account, along with other impediments which come with the territory of doing business in a foreign country.
Inverse Index Funds and other derivatives. The inverse index funds represent one of the newest forms that ETFs have taken. The inverse funds are an extremely easy tool that traders can use to go short the market, without actually “going short.” With inverse index ETFs, if the underlying index rises, then the ETF falls, and vice versa. So if you think that the S&P 500 is going down, and you wanted to short the index, you could actually buy the ^SDS^, which will rally when the market falls. The inverse ETFs are a classic example of just how much these new trading vehicles are capable of. They provide investors new opportunities and new ideas to attack old problems.
If the spirit of innovation lives today (it does!), then there is literally no telling what’s next in the world of ETFs. All it takes is for someone to have the money, the time, and the brains to develop a product, and if the market is there, the buyers will come.
John Lee is an Associate Editor at TradingMarkets.com