Published On: Mon, Mar 29th, 2010

ETFs 101 – On The Money!

By Steven L. Pomeranz

 

So, you’ve got a couple of bucks to invest. If so, it is time to learn about ETFs. ETFs is the shorthand way of saying Exchange Traded Funds.

First off, we need to learn a little about investing in an index. An index is a list of financial instruments put together in order to track a particular market. For example, the Dow Jones Industrial Average tracks the

 

Steven L. Pomeranz

performance of 30 large publicly owned companies that are traded in the stock market. A mutual fund investing in these 30 stocks would therefore be called an index fund. The one and only aim would be to give an investor the ability to own something that replicated the movement and performance of these 30 stocks.

 

 

Today, in addition to the Dow 30, there are Mutual Funds and Exchange Traded Funds which invest in all sorts of indexes. Let’s compare them:

The cost of owning a Mutual fund is often higher than an ETF, thus enabling the ETF to earn a higher return.

A mutual fund buyer or seller will receive the price as of the close of the market each day. An ETF can be traded throughout the day which is a significant investment advantage.

Unlike a mutual fund, an ETF can be purchased using limit orders or stop-loss orders, and they can be sold short and traded on margin.

A mutual fund is required by law to distribute capital gains at year end, and ETF does not distribute gains. This feature helps reduce your taxes.

ETFs are not perfect, however. They do have some disadvantages relative to mutual funds. ETF’s lend themselves to a higher degree of trading and short-term speculation which can lead to underperformance if used unwisely.

ETFs generate brokerage commissions which even though low at many discount brokers, can add-up over time and reduce returns.

Many ETFs now track arcane and complicated baskets of securities which are untested in the marketplace. These types should be used with care.

Finally, some ETFs magnify the movement of an underlying index by 2 or 3 times making them a dangerous instrument even in experienced hands.

There a many more differences both good and bad between ETFs and their mutual fund counterparts, so their use should be understood before an investing. On balance speaking as an experienced advisor, I can recommend their use in most instances.

Do you homework first however, and remember you must always “know what you own” before committing your first dollar.