Wednesday, February 26, 2014

Exchange Traded Funds

An Exchange Traded Fund (ETF) is basically a mutual fund (usually an index fund) that is bought and sold on a stock exchange rather than through a mutual fund company or by a commission salesperson.

They have only been around for a few years, so as an asset class companies are continuing to develop their offerings. It looks like the ultimate outcome will be ETFs that mimic just about every kind of mutual fund that currently exists.

Like traditional index funds the ETF offers diversification at a very low cost, sometimes lower than the comparable mutual fund. The big difference between ETFs and traditional mutual funds lies in how they are bought and sold. Every day a mutual fund must calculate its net asset value. Everyone who buys or sells shares of a particular mutual fund on that day gets the net asset value. Usually there is a time lag between when customers place a buy or sell order and when that order is actually executed. ETFs are different. If the market is open your buy or sell order is executed in real time. The managers of ETFs do not need to calculate net asset value. You buy or sell at the market price at that moment in time.

Because shares in an ETF are bought and sold like shares of stock, the customer will be hit with a brokerage fee on the way in and on the way out. These days that would run about $9.00 for most people, although depending on the brokerage house I have seen as low as $7.00 or as high as $19.00. If you are buying shares of ETFs in multiples of $1,000 this is a very inexpensive way to buy and sell. If you are buying $100 at a time the fees are killers, even worse than funds sold with a 5.75% sales commission and 12 B-1 fees. If you are a dollar cost averaging kind of investor, go ahead and pony up the $3,000 needed to start buying mutual funds at Vanguard, then let them automatically debit your checking account for $100 a month. Even though you will be paying slightly more in management fees you will be saving an enormous amount of money over the course of many years.

Like index funds, ETFs should be viewed as a long term investment. Ideally you buy and never sell except to rebalance your portfolio. Some argue that because it is more difficult and time consuming to buy and sell index funds sold through a fund provider than it is to trigger a trade through a brokerage house, the small time investor should stick with mutual funds. All too often the small investor is driven by fear and greed. He is afraid when the market is dropping. Then he sells at exactly the wrong time. He gets greedy when the market is at record highs. Then he buys at exactly the wrong time. Putting even a small inconvenience in the way of this predilection helps to control instinctive bad behavior. I am not sure I buy this argument. With the advent of the Internet and cloud computing it isn’t really all that much more difficult to buy or sell mutual funds than it is to buy or sell shares on a stock exchange.

Self discipline is up to you. Your positions in index funds or ETFs are foundational investments. Buy and don’t sell (except to rebalance) then the money will be there for your retirement and if you are diligent and a little lucky for children’s college education.

A couple more things to think about are reinvesting the dividends and capital gain distribution. If you can reinvest the proceeds from your ETF without any brokerage fees that is a good thing. If your brokerage house wants to charge you for that service, you might want to take your money elsewhere. In thinly traded ETF, as in buying or selling shares in small unknown companies, there can be a significant difference between “bid” (the price the market is willing to pay you for your asset) and “ask” (the price you will pay to buy the same asset). For example, on a given day the “bid” price on XYZ Corporation is $50.00 a share. That is what the market is willing to pay you for your shares. Let us assume that if you want to buy shares of XYZ on the open market you would need to pay the “ask” price of $50.50. The difference (called the spread) would be $0.50 a share. Usually the spread is microscopically small and of no concern, but in some cases it can be a consideration.

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