Investing in Exchange-Traded Funds (ETFs)

Brian Hicks

Updated April 3, 2008

It seems like everywhere I go these days, I’m bombarded with questions about investing in exchange-traded funds. And I can’t say that I’m surprised by it-not by a long shot.

After all, these funds, widely-known as ETFs, are practically a growth industry in and of themselves these days. New ones, it seems, spring up on nearly a daily basis.

In fact, these funds have become so popular lately that I think that 2008 may well go down as the year of the ETF.

In the U.S alone, there are now 533 ETFs with over $530 billion invested in them.

But what surprises me the most about these questions is how little the average investor actually knows about ETFs.

And that’s exactly where the majority of new ETF investors end up making the most mistakes. Mutual funds they are not.

So what is an Exchange-Traded Fund?

First developed in the 1990’s, exchange-traded funds are in many ways the best of both worlds. That’s because they combine they ability to make a broad sector bet as you would in a mutual fund, with an instrument that performs on a day-to-day basis much more like an individual stock.

Let me explain.

In short, what an ETF represents is a security that tracks an index, a commodity, or a basket of assets. That makes them quite similar to what you would find in any mutual fund.

However, what makes ETF’s different, and in some cases more effective than mutual funds is that they can be bought and sold throughout the day just like stocks on an exchange.

As such, these exchange traded funds allow individual investors the ease and safety of diversification while still allowing for all of the ordinary features of an equity, such as limit orders, short selling, and options.

Moreover, unlike shares of a mutual fund, whose price can only be determined by its Net Asset Value (NAV) at the close of the day, the value of a share in an ETF can go far beyond its underlying value as investors bid up the shares.

Smart traders, of course, love this fact and use it to their advantage as the make their broad sector bets.

So while mutual funds are relatively passive investments whose true worth is based solely on the actual share price of the stocks owned by the fund, an ETF investor needs to be more active in managing those shares.

An Example of an ETF at Work

Here’s a recent example of exactly what I mean.

Just a few months ago, as I turned my skeptical eye on the Chinese stock market, I made a few recommendations to my Wealth Daily readers on how to turn a profit by going short China.

One of them was to go long with an ETF called the FXP.

That’s the symbol for this mouthful: The Ultra Short FTSE/Xinhua China 25 Proshare.

It’s what’s called an inverse ETF.

That’s nothing more than a fund that is designed to trade counter to another ETF-in this case, inverse to the iShares FTSE/Xinhua China 25 Index (FXI).

To make along story short, I told my readers that if you wanted to make a bet against the Chinese market bubble, one way to do it would be to buy shares of FXP. (Shorting the FXI would be another)

Simple enough…

But unlike a mutual fund, whose share price could only be determined by its net asset value (NAV) on a given day, FXP was able to trade much higher than its NAV.

That makes a choosing an ETF based solely on its net asset value about as questionable as buying a stock based only its a P/E ratio-which by the way is the biggest mistake that most market newbie’s make.

In fact, shares of the FXP ETF went as high as $122.00 while its NAV remained at $94.74.

So in the end it wasn’t the value of the underlying assets that determined FXP’s price, but the laws of supply and demand.

And if you had bought shares of FXP the day after the story ran you could have sold your shares of FXP for a gain of 40.42% only 8 weeks later!

Just try to do that with your mutual fund.

If you do, you’re likely to be sadly disappointed. They just don’t work that way.

Of course, keep in mind that those same laws of supply and demand that govern the price of an ETF, can also work in reverse. ETF’s can and do trade below their NAV.

That’s why investors in these funds need to keep a very close eye them. Passive mutual funds they are not. And that perhaps is the single most misunderstood aspect of these funds.

The Advantages of Investing in an Exchange-Traded Fund

Nonetheless, ETF’s do offer other advantages beyond mutual funds. They include:

  • Tax Efficiency: Unlike a mutual fund that must pass along its capital gains to its shareholders, an ETF is usually taxed only when the shares themselves are sold. That tends keep the ETF investor safe against unexpected capital gains at the end of a quarter.
  • Lower Fees: ETFs are no-load funds. That means that you won’t be slapped with a redemption fee when you decide to close your position. Moreover, ETFs typically have lower annual fees than traditional Mutual Funds.
  • Liquidity: The exchange-traded structure of ETF gives them much greater liquidity in the markets. That allows ETF investors to close their positions much faster than a mutual fund, which must be liquidated at end of day.
  • No Minimum Investment: Diversification can be tough for new investors-especially if you’re using a mutual fund. That’s because traditional mutual funds frequently have a minimum investment of $2,500 or more. ETF’s, on the other hand, carry no minimums making for easier asset allocation.

As for the ETF’s themselves, there are ETFs to cover every major index, asset class, and niche an investor can imagine. Tech, energy, gold, real estate, oil, you name it and there is an ETF that covers it.

In fact, an entire portfolio of diversified investments can be created quickly and simply by using ETFs.

But be warned. As attractive as these investments have manage to become to retail investors, they can be as dangerous to their portfolios as individual stocks.

Next week we will take a look how to separate the good ones from the bad.

Your profit-hungry analyst,

steve sig

Steve Christ

Chief Investment Strategist

The Wealth Advisory

P.S.— Green Chip Stocks just recently launched a green chip fund index that is also providing investors with added wealth security, and of course, profits. Click here to learn more.

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