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Exchange-Traded Fund (ETF)

Exchange Traded Funds (ETFs) are a fairly recent phenomenon, and as such the information I've been able to find is limited and heavily skewed. I've pored over it with a critical eye and a nose for hype, and the following notes are my attempt at sorting things out.

Basics

As the name implies, an Exchange Traded Funds is a mutual fund whose shares are traded on the open market. For large or institutional investors, an ETF may be willing to sell or redeem shares directly, but this is generally done in large blocks (hundreds of thousands of shares) and is of no significance to the average investor.

Operationally, an ETF is managed by a fund manager who oversees the investment of the fund's resources. There are various legal and regulatory differences between a mutual fund and an ETF, but this is also immaterial to the investor.

Typically, an ETF represents a specific "basket" of investments (stocks, bonds, currencies, commodities, etc.) that is generally held long-term by the fund. While it is possible for an ETF to be actively managed, a quirk in the regulations makes it difficult to establish an actively managed ETF, and the required degree of openness makes it difficult for a fund to operate secretively (which is necessary to move ahead of speculators who may wish to observe the fund to mimic or exploit its strategy).

For that reason, most ETFs are married to market indexes, or purchase a specific class or variety of investment (such as large-cap stocks, high-yield bonds, or gold futures) in pre-determined proportions that do not vary much over time. This also allows the investor to choose an ETF according to his risk tolerance or speculation about the performance of specific market sectors.

Investment Comparison

Most sources describe an ETF as a hybrid of stocks and mutual funds, stressing its differences from those forms of traditional investment. Depending on whether the source in question is attempting to encourage or discourage investors, the advantages or disadvantages are stressed. What follows is a compilation of the information/opinion of both sides.

ETF vs. Stock

From an investor's perspective, buying and selling shares of an ETF is identical to buying and selling shares of stock: an investor places a bid, and if another party is willing to buy/sell shares at the stated price, and exchange takes place.

Some sources warn of illiquidity: if there is insufficient market action, an investor may not be able to buy or sell shares at any price. Others claim that this is a "myth" and that market makers will act to stimulate trade in order to ensure that there is liquidity.

It seems to be generally accepted that an ETF has less volatility than an individual stock, in that the customer is buying into a diversified bundle whose individual fluctuations offset one another, such that the increase or decrease in value is gradual.

Also, while the effects of speculation can temporarily skew the value of shares in an ETF, the value is generally stable and reflects the actual market value of the securities it represents ... and while each of the individual securities is subject to speculation, the cumulative effect is mitigated, though a sector ETF (e.g., one that specializes in heavy industry) will be subject to speculative effects upon the sector.

It's also suggested that most ETFs do not pay dividends, which can be painted as a disadvantage for investors who seek a regular stream of income, but an advantage to investors who prefer to manage the profit they take (hence the taxes they must pay in a given calendar year).

ETFs are also more transparent than individual companies: they must disclose the investments they hold and cannot jigger their accounting to create a false impression of their value (though, again, they suffer from the cumulative opacity of the individual securities they represent).

ETF vs. Mutual Fund

It is more common for an ETF to be marketed (and used by investors) as an alternative to traditional mutual funds.

One of the primary advantages is said to be flexibility in fund choices: to hold shares in a mutual fund, an individual must open an account with a company that manages the fund, making it inconvenient for an investor to hold funds managed by several different companies. And while fund "supermarkets" exist, there are often added commissions, and not all funds are available to all supermarkets.

Another advantage is said to be flexibility in investment amounts: most mutual funds have a minimum initial investment and charge penalties if a balance falls below that amount. While it is true that a person can own a single share of an ETF, a commission is charged on each sale, making it counterproductive to buy and sell in small amounts.

Another advantage is that ETFs have better performance than mutual funds, because there is no need to have a cash reserve to purchase shares from investors (such that 100% of the fund's assets can be invested and "working" at all times). Also, since shares are generally created or redeemed in large blocks, there are fewer transactions than traditional mutual funds, so management fees tend to be lower.

Another advantage of an ETF is that, unlike mutual funds, an ETF is not required to pay out dividends and capital gains to shareholders, which enables the investor to manage the tax impact of their investment (taxes are due only when shares in the ETF are sold), though this may be seen as a disadvantage to investors who seek to receive a stream of income from their investments.

The transparency of an ETF (regulatory requirement to disclose all holdings to investors) s regarded as an advantage by some and a disadvantage by others. The reasons it is considered to be an advantage are generally trust (the investor cannot be verify the value) and more frequent reporting (the ETF's value can be monitored in real-time), but the disadvantages are that the ETF is open to inspection by speculators.

A disadvantage of ETFs is that shares are traded on an exchange, and there is typically a brokerage commission paid on each transaction, whereas moving funds into or out of a mutual fund is typically commission-free (unless the fund has a load or transactions are placed through a fund supermarket).

Another disadvantage of ETFs is the necessity to trade in whole shares, such that the investor cannot buy or withdraw a specific dollar amount, but must buy or sell whole shares based on an estimation of their actual value.

And last, it is not practical for an investor to accumulate a holding in an ETF in small amounts (such as they may do in a mutual fund that allows the investor to make small deposits periodically). It is entirely possibly, but the commission on small transactions erodes the return on the investment.

Misc. Notes

The history, management, and other information is of little value and passing interest to making investment decisions, but for what it's worth ...

While ETFs have gained in popularity in recent years (some sources call it an "explosion"), it is not entirely new. In essence, an investment holding company is a kind of ETF, in that the firm's assets are comprised entirely of investment vehicles, such that buying a share in the holding company is the equivalent of buying a basket of investments.

A few attempts to establish funds whose shares were traded on the open market were made in the 1980's by exchanges, but these were halted by regulators and lawsuits, but the popularity of this tactic led independent investment houses to create such funds shortly thereafter, and the popularity of index funds and commodities funds led to increased supply.

Regulation of this "new breed" of investment vehicle has been clumsy but well intentioned, as there are conflicting jurisdictions between the entities that govern the types of investments they may hold. The results have been both positive (such as providing transparency) and negative (such as preventing ETFs from availing themselves of certain types on investment), and it may take years or decades to shake out.