Exchange Traded Funds (ETF's)
The Pros and Cons
There are now many types of investments available to investors like you and me. From cash, stocks, bonds to mutual funds, financial opportunities abound. So, how do you choose one that is right for you? First, don’t just chose one, rather round out all of your investments with a variety of investments to exploit each of their strengths and lessen their weaknesses.
Exchange Traded Funds are another type of investment which you can be selected, but before you jump in, make sure you know the pros and the cons of ETF’s.
First, What is an Exchange Traded Fund?
Exchange Traded Funds are funds which pool money from many investors, similar to a mutual fund, for targeted investment purposes. Introduced in the United States in 1993, ETF's combine mutual fund and stock trading into a single investment vehicle.
They allow you to be financially involved in the growth of a particular industry or segment (such as the energy industry) and are traded on an exchange just like regular stocks. Exchange Traded Fund performance is dependent on the performance of all the shares of stocks it holds in all the companies it is invested in which, ideally, will closely follow the performance of the index the fund is mimicking.
According to the U.S. Securities and Exchange Commission, “Exchange-traded funds, or ETF's, are investment companies that are legally classified as open-end companies or Unit Investment Trusts (UITs), but that differ from traditional open-ended, like a mutual fund, companies and UITs.”
Exchange Traded Funds are set up to mimic certain stock market induces such as the S-500, the Nasdaq or the Dow. Moreover, there are literally hundreds of ETF's tracking all sorts of stocks or industries, like share in gold, oil shares or even foreign traded stocks, to name just a few an investor can chose from. As an investor you can also trade ETF's that follow bond induces.
Whatever your investment goals, there just may be an Exchange Traded Fund which can help you meet your goals.
Benefits of Exchange Traded Funds
There are several major benefits to trading in ETF's. Like a mutual fund you have diversification across different stocks in a given industry which should lessen your risks somewhat. You can choose the industry, and in many cases, you can concentrate your investment more directly in a particular sector than you are able to with a mutual fund.
Because ETF's are created to mimic induces, they entail lower management and trading costs. Also, because they are bought and sold like stocks on the open market, you can get in and out of an ETF for only a few dollars per trade with a discount broker.
No-load mutual funds carry no trading costs - they do however carry management fees that, for a good fund, are in the area of 1%. However many mutual funds will charge redemption fees if you don't stay in the fund for a particular length of time – sometimes more than six months. There are absolutely no restrictions on buying and selling ETF's.
Another major advantage of an ETF over a mutual fund is that it is continuously priced throughout the day and can be traded whenever the markets are open. Traditional mutual funds are priced at the close of the market each day and purchases and sales are only settled at that time and often posted the next day.
Finally, there is the down-tick rule. When the Dow is down more than 170 points, you cannot short a stock until there is at least one trade to the upside. This is meant to prevent a rout. ETF's have been exempt from this rule, so it can be used as a short selling vehicle on down days.
Drawbacks to ETF’s
There are a few drawbacks to ETF's. You don't get professional management of your money, you are only mimicking an index. For that reason, many experts do not advise the use of ETF's for long term investments.
If you don't know what you're doing, you may be swayed to jump in and out of these investments at the wrong time. But this is not a problem limited to ETF's and if you don't know what you're doing with stocks, you shouldn't be trading them either. There is no opportunity to buy without a brokerage commission, but this may be offset by the low management fees.
Finally, the major risk associated with sector investing is that you pick the wrong sector. Diversification across a sector doesn't cushion you from loss if the sector is in a free-fall and all the stocks are on their way down. A better long term strategy is to invest across different sectors, with the hope that some sectors will hold their own or even rise while the rest of the market is falling. That is the balance you can achieve with ETF’s.
All in all, Exchanged Traded Funds are useful investment tools, especially for short term use of your money. The more you learn about various sectors the better your investment choices will be and you could even use ETF’s for longer investment periods, which will reduce your trading expenses. They make a good choice for any portfolio and should be investigated by everyone.
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