Five Things You Should Know About ETFs

CATEGORIES: Investment Analysis

ETF investing
Exchange-Traded Funds (ETFs) have grown over the past twelve years, from less than $100 billion in 2000 to over $1.2 trillion in 2012 for the U.S. market alone.

Are they right for you? Here are five things that can help you make that decision:

1. What is an ETF?

Exchange-traded funds are a type of “pooled” investment vehicle. That means they are single tradable entities containing multiple assets. An ETF might hold dozens or hundreds of stocks, bonds, commodities or currencies.

ETFs were originally designed to track a specific market benchmark, like the S&P 500 or the Barclays Aggregate US Bond index. In this way ETFs are similar to index funds. Like index funds, ETFs are “passive” investment vehicles – their purpose is to try to replicate the performance of a market benchmark, not to outperform it.

2. How do ETFs trade?

ETFs trade like regular shares of common stock. That means they sell on a stock exchange with prices changing throughout the trading day.

You can go to any popular financial news site, like Yahoo! or Wall Street Journal Online, type in the ticker symbol EPP (iShares MSCI Pacific ex-Japan Index ETF, used here as an example) and see its current share price, time of last trade, transaction volume, 52-week high/low, P/E ratio etc.  These are all the metrics you see for any ordinary share of stock.

This is convenient for ETF research and trading, and it is quite different from the way mutual funds trade.  Mutual funds price once at the end of each trading day, and investors buy and sell (“redeem”) based on the Net Asset Value reflected in that price.

3. What are fees like?

Mutual funds come in several varieties: front-end or back-end load, retirement, institutional and so forth.  Each class reflects different types of fees. These fees include sales load, redemption, 12b-1 and other varieties.

ETFs typically are limited to only management fees (and occasionally other operating expenses).  Because they are passively-managed, ETFs will generally have lower management fees than actively managed mutual funds.  In fact, according to a study produced by the ETF company iShares, ETF management fees are considerably lower than those for passively-managed index funds as well.

4. What asset classes can I access?

ETFs represent a huge range of both broad and narrow exposures.

You can buy an ETF reflecting the market for US large-cap value stocks, or the Chilean stock market, or the 7-10 year US Treasury bond market. You can buy ETFs representing specialized commodities, from crude oil to gold.

This makes ETFs a very handy instrument for portfolio construction. You can diversify your portfolio through ETFs. Moreover, because ETFs have a low tracking error relative to the benchmark, your performance will be more directly related to the asset class, rather than the fund manager’s decisions.

5. Are ETFs the same as ETNs?

ETNs are Exchange-Traded Notes, and they are not the same as ETFs.

ETNs are a variety of a complex type of asset known as “structured products.”  These are essentially comprised of bonds issued by an AAA-rated financial institution containing one or more options or other derivative instruments like swaps.

ETNs are often used to invest in exotic asset classes like copper, liquid natural gas, or a frontier stock market like Indonesia.  Approach these instruments with caution, as they come with certain risks that are not features of ETFs.

As with any investment, you want to conduct your ETF research thoroughly before wading into the ETF pool.

A good rule of thumb is to focus your ETF research on fund families that have been around for awhile, like iShares, PowerShares or SSGA’s SPDR fund family.  You can find fact sheets about each ETF, including return and risk metrics, fund holdings and other important information, through the fund family.

Also remember that while ETFs can take you all over the world (in terms of asset class exposure), they won’t shield you from the risk of investing in volatile markets. Investing is risky – with ETFs or otherwise.


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About the Author

Katrina Lamb is a CFA for Jemstep. She has over 25 years experience in economics, finance, international development and management strategy, with a strong focus on global markets. She provides a voice of clarity, logic, and reason in an environment characterized by high uncertainty.

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