What Are Exchange-Traded Funds?
When most people think of stock funds, they think of mutual funds. But a new class of stock funds are growing in popularity, thanks to powerful advantages that deserve your attention.
Exchange-traded funds offer the diversification of index mutual funds by spreading your invested dollar among the stocks of many different companies. But ETFs hold two key advantages over their traditional cousins.
First, ETFs operate under the same tax rules as mutual funds, but the ETFs have figured out a way to avoid distributing capital gains. This makes ETFs worthy of consideration, not only for the trader but for the long-term investor as well. How ETFs accomplish this requires a somewhat technical explanation. But the upshot for you is that ETFs don’t incur capital-gains taxes once a year like mutual funds, because they have no taxable gains to distribute.
You become subject to capital-gains taxes only when you sell your ETF shares at a price above your purchase price. In that regard, ETFs act just like stocks. ETFs do, however, have to distribute cash dividends, just like mutual funds, and these distributions are taxable. More on this later.
Second, as the name implies, exchange-traded funds are bought and sold, and priced and repriced throughout the day in the financial markets. These “tradable funds” are quoted in the financial markets just like stocks, their bid and ask prices adjusting throughout the day, in response to supply and demand.
That amounts to a major departure from mutual funds. Take the Vanguard 500, the index mutual fund that tracks the S&P 500 index. Throughout the day, the stocks that make up the index trade and change in price, and the S&P 500 fluctuates accordingly.
But the net-asset value of the Vanguard 500 changes only once a day. At the end of each trading session, the mutual fund companies rush to recalculate the Net Asset Value of their fund shares based on the closing prices of those funds’ holdings, net of fund expenses.
This makes open-end mutual funds useless to the short-term trader who might want to play an intraday market move.
For example, let’s say a trader is watching the trading action on the S&P 500. The index dives in the morning, reflecting a market sell-off. Then cash comes stampeding back into stocks, and the S&P reverses and starts to come off the lows.
A short-term trader who figures out the S&P is beginning a big one-day bounce couldn’t use the Vanguard 500 to play the move, because his purchase price would reflect the S&P’s market close, not the index level at the time he entered his buy order.
“With mutual funds, you get that day’s closing price,” said Jim Novakoff, a designer of portfolio models for institutions and partner of Levitt, Novakoff, a Boca Raton, Fla.-based investment firm. “Now there are some complications, because not all funds close at the same time. In some cases, you need to have the trade done by 3:00 p.m. to get that day’s closing NAV. Sometimes, it is 4:00 p.m. or 5:00 p.m.”
On the other hand, you could take advantage of the same hypothetical opportunity using Standard & Poor’s Depositary Receipts (SPY), a tradable fund listed on the American Stock Exchange. SPDRs, or Spiders, trade throughout the day. You’re in your Spiders at their share price at the moment your order executes.
The similarities with stocks don’t stop there. Because they trade on exchanges like stocks, you can buy tradable funds on margin, meaning you borrow from your broker to increase your holdings. You can short exchange-traded funds just like stocks. In other words, you can borrow ETFs from your broker and sell them in hopes the share price will decline. If you’re right, you buy back the same number of shares, then pay back the loan at a lower price, pocketing the difference as a capital gain.
Tradable funds also entail no front-end or back-end loads and no redemption fees, costs that can eat away at the trader’s profit margin. However, you must pay a brokerage commission to buy or sell ETF shares, just as you would to buy or sell stocks.
ETFs also pose two other disadvantages that you should consider before deciding whether they suit your purposes vs. other trading or investing instruments.
Like stocks, you will encounter “slippage” if you trade ETFs. To understand slippage, you must understand the bid-ask spread. If you buy a listed security (like an ETF or stock) through a normal brokerage account, you will pay the lowest price offered by the current sellers. This is called the “ask” or the “offer.” If you sell a security, you will sell to the buyer bidding the highest price for that security.
For instance, the highest buyer may bid 20 1/2, and the lowest seller may ask 20 3/4. So the bid-ask spread would be 20 1/2 to 20 3/4. Any stock price you see as a buyer is different from what a seller sees. The quarter-point gap amounts to slightly more than 1 percent of the stock price to the buyer or seller. This cost is called slippage. Another disadvantage regards reinvestment. Your mutual fund can use cash dividends of its stock holdings to acquire more stock and more fund shares for the fund shareholder. ETFs like Spiders and Diamonds do not offer this reinvestment option. Instead, they pay out quarterly cash dividends from the accumulated dividends of the underlying stocks.
In this regard, mutual funds hold the advantage. You can sidestep the brokers and establish accounts directly with the mutual fund families, avoiding commission costs (but in many cases incurring load and/or redemption fee costs).
The pioneer of ETFs is the American Stock Exchange. As of the end of February 2000, the Amex listed 34 distinct ETFs for trading. For discussion purposes, you can break these down into four categories.
There are “domestic” ETFs, as Novakoff refers to them. They include the SPDRs (SPY), which track the S&P 500; the MidCap SPDRs, which track the S&P 400; the Nasdaq-100 Index Tracking Stock (QQQ), nicknamed the “Cubes,” based on the 100 biggest non-financial Nasdaq stocks; and the Dow Jones DIAMONDS (DIA).
State Street Bank and Trust Company of Boston, the administrator and custodian of the Spiders, also has trotted out “Select Sector SPDR Funds.” These instruments “unbundle” the S&P and give investors ownership in particular industrial sectors.
These include Basic Industries Sector (XLB), Consumer Services Sector (XLV), Consumer Staples Sector (XLP), Cyclicals/Transportation Sector (XLY), Energy Sector (XLE), Financial Sector (XLF), Industrial Sector (XLI), Technology Sector (XLK) and Utilities Sector (XLU).
Merrill Lynch has launched its own set of sector-focused securities, called Holding Company Depositary Receipts, or HOLDRs. As of May 5, 2000, Merrill Lynch had listed nine HOLDRs on the American Stock Exchange: Internet (HHH); B2B Internet (BHH), Internet Infrastructure (IIH), Internet Architecture (IAH), Biotech (BBH), Telecom (TTH), Semiconductor (SMH), Broadband (BDH) and Pharmaceutical (PPH).
Another Merrill Lynch HOLDR, the Telebras HOLDR (TBH), trades on the New York Stock Exchange. This financial product was created in June 1998 to enable investors to trade in a single transaction the 12 companies born from the breakup of Brazilian telecom monopoly Telebras.
The Merrill Lynch HOLDRs differ in an important respect from the other ETFs. Each HOLDR product represents a fixed basket of 20 stocks, with the exception of the Telebras HOLDR, which holds 12 companies. Once a HOLDR is created, its component stocks are locked in. The index-based ETFs, however, drop and substitute stocks to keep pace with their underlying indexes.
The HOLDRs trade in round lots of 100 shares. Each round lot represents a fixed number of shares in the component stocks. There is a way around the round-lot requirement. “You can acquire shares in odd lots only if you get the HOLDR from Merrill Lynch directly. Then you can get a split share,” Novakoff said. “Apparently, ML bought some software that allows them to track split shares.”
It also is possible to own, through a single security, an interest in a basket of stocks tied to the benchmark index of a foreign country. Have you a strong opinion that one country may outperform the U.S. market in the short, intermediate or long term? Consider World Equity Benchmark Shares, WEBS. As of the end of February 2000, the Amex listed WEBS that address 17 countries: Australia (EWA), Austria (EWO), Belgium (EWK), Canada (EWC), France (EWQ), Germany (EWG), Hong Kong (EWH), Italy (EWI), Japan (EWJ), Malaysia (EWM), Mexico (EWW), Netherlands (EWN), Singapore (EWS), Spain (EWP), Sweden (EWD), Switzerland (EWL), and the United Kingdom (EWU).
“In addition to ETFs’ tax advantages, it is possible for experienced, active traders to implement index-based structured trading strategies with ETFs — a personal hedge fund,” Novakoff said. “In fact, ETFs were first designed for hedge funds. It is difficult and, in many cases, impossible to implement hedge-fund-like structured strategies using mutual funds. Mutual funds, on the other hand, have some important advantages for long-term investing, including no brokerage fees and direct contact with the fund company. Mutual funds are now the instrument of choice for 401(k) programs, for example.”
For more information on the Amex-listed ETFs, you can download a prospectus from the American Stock Exchange.
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