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Are Exchange Traded Funds Right for You?
Exchange Traded Funds
At the end of last year, the investment world lost a visionary. Nate Most, the inventor of the Exchange Traded Fund or ETF passed away at age 90 leaving a fundamental change in how investors use the American Stock Exchange, the red-headed step child of Wall Street. Back in 1993, he introduced the Spider, a fund that traded like a stock but mimicked the Standard & Poors 500 Index of large cap stocks.
This type of tradable index fund shed new light and increased revenues on the beleaguered Amex and as of his passing, accounted for half of the shares changing hands. These funds have now become a force to be considered among the investment community although the $7.2 trillion mutual fund industry still makes light of the threat. Quickly advancing in terms of tax efficiency, lowered fees, and convenience, the ETF has come into its own as a place of indexed protection.
Vanguard has launched its own imitations of ETFs called VIPERs with many other funds creating similar offerings. While this is a typical form of Wall Street flattery, many fund managers have found the ETF an excellent place to equitize their cash reserves. Another benefit of these offerings allows fund managers to actively play industries or sectors that they perceive to be attractive. The risk is not eliminated however and may even be heightened. Many ETFs give the appearance of balance but may in fact be heavily weighted with large holdings creating a disproportionate amount of the index's investment.
Moving away from a strictly equity based fund, a gold index fund from streetTRACKs was based on the commodity with each share offering a portion of an actual ingot. Initially Wall Street believed such an offering would entice foreign investors away from dollar based investments such as Treasuries to an offering with an actual metal attached.
The Net Asset Value of ETF is calculated in much the same manner as a mutual fund would. The NAV calculated by the mutual fund does not reflect supply and demand. Supply and demand are primary forces in the open market and because of that, the share price of an ETF may be trading higher or lower than the underlying worth.
ETFs outperform mutual funds in terms of flexibility though. The ability to trade throughout the day is one of the primary attractions for investors interested in ETFs. Frequent traders however may fell the sting of commissions more than those who chose another longer term strategy.
Two things make these shares worth avoiding. The first is that pesky problem of discount. In a market correction, ETFs may be on the surface, worth more than the NAV of the securities they represent.
The second deals with expenses and the possible illusion that you are saving money. I have always encouraged dollar cost averaging, low expenses, and low entry fees for the mutual funds here at the BlueCollarDollar. ETFs would not fit that criterion. Dollar Cost Averaging, the act of making regular and steady contributions to a fund to offset high and low markets would rack up an enormous amount of commission costs. One lump sum purchase, perhaps with a windfall or a tax return check would be the best wait to fully realize the value of such a trade. This is the very reason Dollar Cost Averaging works so well.
Buying the NASDAQ 100 or ticker symbol QQQ, a tech laden grouping of the top stocks on the NASDAQ at the high dollar mark of $110 would find you with a share worth two thirds less today. Using dollar cost averaging, the hypothetical investor would be purchasing shares at this greatly discounted price and with any luck, it will offset the share they bought back in '00. The current closing price at this writing (08.27.03) is down only 10% from the inception price of $50.
Expenses are considerably less than many index funds but this is also a smoke and mirrors effect. Unless you hold onto the ETF for a sufficient amount of time to offset the cost of the purchased ETF and the expenses, you are probably better suited for a mutual fund.
One of the most under considered expense is taxes. In a mutual fund, an investor sells shares and the whole fund feels the ripple effect. In order for that investor to receive the value of their investment, the fund must sell something to pay off the departing shareholder. This can negatively impact the remaining long term investors. If the stocks that are sold have experienced gains, taxes must be paid.
Fortynine: What is front running?
The choice of ETFs over mutual funds should be considered very carefully. In a long term investment strategy that employs dollar cost averaging, the benefits of ETFs fade very quickly.
The introduction of actively traded ETFs, however will present new opportunities for small fund companies but at the same time, effect the transparency currently being touted by brokerages will come under fire. Too much transparency will allow for front running and free riding, problems that do not effect actively traded mutual funds whose portfolios are closed during the trading session and are rebalanced at the end of each day.
Below you will find a list of these funds along with some pertinent information.
The NASDAQ 100 Index reflects NASDAQ's largest companies across several major industry groups, including computer and office equipment, computer software and services, telecommunications, retail/wholesale trade, and biotechnology.
SPDRS
SPY SPDR 500
iShares Funds
iShares are a family of open-ended exchange-traded funds that seek to track the performance of any of an array of market indexes, such as the Russell 2000 Value Index or the Dow Jones US Consumer Cyclical Sector Index.
IWM iShares Russell 2000 Index Fund
Diamond Funds DIAMONDS is the common name for a specific index ETF that seeks to track the Dow Jones Industrial Average (DJIA) index by investing in the constituent stocks of this index.
streetTRACKS Funds
streetTRACKS is a family of exchange-traded funds that are marketed by State Street Capital Markets and represent ownership in the streetTRACKS Series Trust, an index fund that consists of separate portfolios of common stocks. Each fund is designed to track a specific index, such as the Dow Jones Total Market Index Series (US Large-Cap Value, US Large-Cap Growth, US Small-Cap Value, US Small-Cap Growth), Morgan Stanley Internet Index, Fortune 500 or the Fortune e50 Index.
DSG streetTRACKS DJ US Small Cap Growth
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