Wednesday, January 30, 2008

Word o’ the Day: Exchange Traded Fund (ABC’s of Financial Planning)

“Tryin' to make it real — compared to what?”
- Les McCann (“Compared To What?”)

Exchange Traded Funds, commonly referred to as “ETFs” are usually defined as “compared to what”. This is because ETFs are unlike almost any other investment vehicle. I usually start my ETF discussion with “Compared to mutual funds…” but that presumes a depth of knowledge in the listener that they usually have yet to attain. And I like to keep discussions of investment esoterica down to earth in language that doesn’t require an immediate consultation of the dictionary. Let’s see if we can “make it real”.

Exchange Traded Funds are baskets of securities -
OK, what’s a “basket of securities”? Where does “basket” come from? Maybe “bucket” would be a better analogy. So, a “bucket of securities”. In one hand you carry the bucket and with the other hand, you select securities to put in the bucket. “Securities” (usually) means stocks or bonds. If you want to construct an ETF that follows the US stock market, you would put stocks of large US companies in the bucket. Examples would be GE, IBM, Microsoft, Boeing, Wal-Mart, ExxonMobil, etc. The individual stocks and the amount of each that you would put in the bucket would be based on an index – a 4-bit word meaning “list” - such as the Standard & Poor’s 500 Index.

Exchange Traded Funds are passive investments constructed to follow the performance of an index -
What is a “passive investment”? A passive investment is one that is not actively managed i.e., a money manager is not reviewing what’s in the bucket and making changes based on what he thinks. The issuer of the ETF decides what index it will follow and the bucket is filled with stocks or bonds that are intended to replicate the performance of the chosen index. Stocks or bonds are removed from or added to the bucket only when there is a change in the index the ETF is following.

Exchange Traded Funds are inexpensive to own -
Because the money in an ETF is not actively managed, the management fees are low. A quarter of a point here, a quarter of a point there – pretty soon we’re talking about a lot of money – your money. Like stocks, you will usually pay a trading commission to buy and sell ETFs.

Exchange Traded Funds are tax-efficient -
Investors do not like paying taxes on their investments, especially when they don’t have control over when the taxes are to be paid. An investor who owns shares in Microsoft can decide when to sell those shares and thus decide when to pay the taxes on any capital gain realized as a result of the sale. An investor who owns a mutual fund can’t do this, because the manager of the mutual fund is in charge of when to buy and when to sell – and the manager doesn’t care about your taxes (he’s not going to pay them – you are). Owning an ETF is like owning an individual stock in that the investor decides when to sell and thus decides when to pay the taxes on any capital gain realized as a result of the sale. This is not to say that owning an ETF is entirely tax-free, but it’s pretty close. Because of the passive design, securities owned by the ETF are only bought and sold when the index being followed changes so there is very little buying and selling and thus, very little in the way of taxable gains over which you had no control. (ETFs will distribute dividends and interest received on stocks and bonds so some taxable income is inevitable). The tax angle gets better though. Most ETFs allow investors to sell their shares and take distribution “in-kind”. This means instead of selling for cash, the investor receives shares of the stocks owned by the ETF – for tax purposes, this is not a sale. (This is definitely esoteric and most people don’t do it this way, but they could).

Exchange Traded Funds are transparent –
You can find out at any time what stocks or bonds your ETF owns. Mutual funds report their holdings on a trailing schedule (often by 90 days or more) so by the time you get the list of what they own it is not current.

Exchange Traded Funds can be priced, bought, or sold at any time during the trading day -
Most people don’t know it, but when you look up a mutual fund price, it is a day old. This is because mutual funds don’t price their portfolios until the markets close – they are not priced in real time. When you buy a mutual fund you won’t know what you will pay for a share until the market closes – that’s why buy orders for mutual funds are only accepted in dollars, not # of shares – no one knows what the share price will be until the fund prices its portfolio at the end of the day. So if the market is moving up sharply and you want to go along, you can do so – today - by buying an ETF just as you could by buying an individual stock.

Exchange Traded Funds can be sold short –
How do you make money when the market goes down? Sell short. Short selling involves the sale of securities you don’t own. Without getting bogged down here, essentially you borrow stocks or bonds from another investor and you sell them. The proceeds from the sale are deposited into your account. If you are right and the price goes down, you then buy the stock or bond in the open market – for less than you sold it for - return the stock or bond to the lender and you keep the difference. You can do the same thing with ETFs. A good way to make money recently would have been to sell short one of the many ETFs that track the financial sector - banks and stock brokerages. Sell short at $60, buy it back at $40 and keep $20 minus the cost of borrowing the stock. You cannot sell mutual funds short. You can't sell short in a retirement account.

In portfolios, I use ETFs for broad asset classes and to make tactical sector bets. We’ll talk about that another time.

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