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Are Exchange Traded Funds Right for You?

Exchange Traded Funds
(updated 08.30.06)
(Editor's note: Since this article first appeared, it has been updated numerous times. Exchange traded funds have exploded in popularity branching off into numerous and even more specific sectors. It almost seems as if new offerings arrive everyday. This is not always in the best interest of the average investor and possibly not to be used in retirement plans either. Here are some additional thoughts on the subject of ETFs written on 02.19.07.)

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.