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The Virtual World of Exchange Traded Funds

ETFs Are Hot Right Now, But are They Right for You?

By Fred Yager
ConsumerAffairs.com

October 16, 2006

Personal Finance • Consumer Prices Edge Up In October • Dodd Bill Addresses 'Too Big To Fail' • Study: Four Types Of Consumers Emerging From Recession • States Worry About Federal Preemption In Consumer Bill • Job Cuts Continue To Fall In October • Consumer Confidence Dips in October, But Rises for Holiday Season • Is The Recession Over? • Economy to Affect Two-Thirds of Families This Holiday • Fed Sees Improvement In US Economy • Consumer Prices Rise Slightly In September • Attorneys General Back Consumer Financial Protection Agency • Gold And Stocks: Are Both Dangerously High? • Study: Americans Crave Better Financial Knowledge • Hiring Begins To Emerge Even As Companies Shed Jobs • Economists Say Worst Of Recession Over • Economy May Force Early Retirements • White-Collar Workers Hit Hard By Recession • Fed Sees Recovering Economy • Six-In-Ten Workers Live Paycheck To Paycheck, Survey Finds • Seven Steps To Saving Money • Survey Suggests Improvement In Jobs Outlook • Stocks Still Outperform, Researchers Claim • Employment Prospects Brighten For Jobless Americans • Job Cuts Rise Following 15-Month Low • Little Sign of Inflation on the Horizon • CFA Applauds Plan to Strengthen Key Investor Protections • Consumers Fall Further Behind On Loans --- • More Personal Finance News

You know you've arrived when the Wall Street Journal devotes a special advertising section to you. And if you're the hottest investment vehicle since the invention of the mutual fund, then you may even deserve it.

But as popular as Exchange Traded Funds or ETFs have become, you should consider carefully whether they would be the right investment product for you, especially if you aren't sure what they are or what the ETF is actually investing in.

Exchange Traded Funds are a relatively new product. Invented in the 1990s they were originally marketed to institutional investors as part of a hedging strategy. Today, they're being sold as less expensive and more flexible alternatives to mutual funds.

But unlike mutual funds that invest directly into a portfolio of stocks or bonds and are fairly easy to understand, ETFs are complex products that involve the equivalent of investing in a parallel universe of virtual shares. Instead of investing in stocks, money deposited in ETFs goes into what are called "creation units."

These virtual shares are linked to a block of underlying securities that in turn are linked to a particular index, such as the S&P 500 or an investment strategy. You can trade ETFs all day long like stocks on whatever exchange they're listed, thus the term "exchange traded" funds.

Today ETFs are being marketed to individuals as a way to invest in broad groups of diversified stocks and bonds or into sharply focused special industry sectors as well as countries and even commodities. That's nice but you should keep in mind that not all ETFs are created equal and that some are a whole lot riskier and more volatile than others, especially those that invest in narrow speculative markets such as oil, or options and derivatives.

One of the biggest selling points for ETFs seems to be the fact that they can be traded at the up-to-the-second price at any time during the day, which makes them more flexible than mutual funds which are priced only at the close of the trading day.

Another plus involves favorable tax incentives. When a traditional mutual fund liquidates stocks in its portfolio and they take a profit, then holders of the mutual fund are responsible for any capital gains taxes. Since ETF's invest in virtual shares that redeem shares for baskets of the ETFs underlying securities, this isn't considered a taxable event and therefore -- voila -- no capital gains taxes.

Are you confused yet?

Now we get to the real tricky part, how ETFs actually work. It all starts with a sponsor like a Barclays or Vanguard or some large financial organization that can handle large stock transactions.

These sponsors create the ETF's investment objective such as diversification, or growth. It then decides which securities will be in the underlying "basket" of securities, and calculates how many ETF shares will be offered to investors. How they calculate this number as well as how much each share should be priced goes under the heading of secret sauce.

Now, let's say a fund sponsor wants to create an ETF that tracks the S&P 500 Stock Index. That means they're going to have to buy a basket of stocks that represent all the stocks listed in the S&P 500. That's going to cost a few million dollars. So the sponsor asks an institutional investor to do it for them, to acquire and then deposit with the fund a basket of securities resembling those in the S&P 500.

In return, the ETF gives that institutional investor one of those "creation units." A creation unit will represent between 50,000 and 100,000 ETF shares. Unlike shares in a traditional mutual fund that are purchased with cash, ETF sponsors require their investors to deposit securities with the fund. Each ETF share represents a stake in every company listed on the S&P 500 Index.

The institutional investor that holds the creation unit is then free to either keep the ETF shares or to sell all or part of them on the open market. When they do, the ETF shares are listed on a number of stock exchanges including the American Stock Exchange, NASDAQ and the NYSE. That's where individual investors like you and I can buy and sell them like stocks through a broker-dealer.

Brokers are selling ETFs like hot cakes, focusing on low fees and those tax incentives.

But they play down the negatives such as the fact there's a commission on every trade, that ETFs don't always trade at their net asset value, and that many are not all that widely diversified. Also most ETFs are just a few months to a few years old and therefore don't have good long-term performance records.

At last report there were 320 different ETFs to choose from, so many that the New York Stock Exchange put out a booklet titled "What You Should Know About Exchange Traded Funds."

The booklet explains the risks involved with investing in ETFs, especially those linked to volatile commodities and ETFs for "shorting" major stock indexes. Shorting means they make money if the index goes down. You can buy an ETF that tracks everything from emerging market stocks to gold.

So when you read an ad that says "there's an ETF for just about everything," just remember they were originally created for sophisticated institutional investors who understand their complexities and who also maintain just about every other kind of investment imaginable.

If you don't grasp how they work, then maybe you should be putting your money into those investments you do understand. At least you'll know for sure where your money is and whether it's growing or shrinking.

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