What is an Exchange Traded Fund (ETF)?

ETFs are securities that state legal right of ownership over part of a basket of individual stock certificates. The intent of the fund is to track an underlying index, such as the S&P 500 Index. In simple terms, ETFs are index-tracking funds; you can think of them as an improved lower cost version of index funds. A key difference between regular mutual funds and ETFs is that ETFs can trade throughout the day like stocks when mutual funds are always priced once a day as of their Net Asset Value at the end of the trading day.

A brief history of ETFs

Mutual funds adhere to the rules of the Investment Act of 1940 which mandated, among other things, that mutual funds cannot trade actively throughout the day. But Congress granted exemption powers to the Securities and Exchange Commission (SEC). Investment companies intending to offer ETFs must apply to the SEC in writing for the necessary exemptions.

The first ETF came in existence in 1989 when the Toronto Stock Exchange introduced the Toronto Index Participation Units. It took another four years for the concept to arrive in the US when the American Stock Exchange introduced its own ETF, the Standard & Poor's Depositary Receipts (SPDRs, better known as Spiders). SPDRs track the performance of the S&P 500 Index. The number of ETFs has exploded in the last few years and we are now approaching 500 ETFs (and perhaps by the time you read this we may have crossed this number as many ETFs are awaiting approval from the SEC).

Advantages of ETFs

There are many advantages of investing in broad based index tracking ETFs. Two of these advantages truly stand out: 1) Lower Costs and 2) inherent Tax advantages.

Index funds tend to have substantially lower costs than active mutual funds. The investors do not have to pay dearly for the privilege of having a hot shot manager whose goal is to beat the "market" by paying him/her and an army of analysts huge management fees; in fact, most of them under perform their benchmarks and it is impossible to pick a manager who will consistently beat the benchmarks year after year. Many academic research studies have shown that over the long term investors are better served investing in broad based low cost index funds. Now with ETFs that cost advantage is even better! For example, you can buy the Vanguard Total Stock Market Index fund (VTSMX) and pay an expense ratio of 0.19% or you can buy the Vanguard Total Stock Market ETF (essentially the same stocks) and pay an expense ratio of only 0.07%. Over long periods of time, such discrepancies in the expense ratios can make a huge difference.

Because of the way that ETFs are created and redeemed, ETFs allow an investor to pay most of the capital gains upon final sale of the ETF, delaying it until the very end. The result is dramatically lower capital gains taxes (which are usually passed on to the investors in those 1099 tax forms each year). Therefore, ETFs work especially well in non tax- deferred accounts.

The ability to diversify by using only ETFs has been enhanced as providers now offer ETFs of just about any asset class that exists. ETFs are now the ideal tool for investors focused on asset allocation. Recent ETFs provide exposure to municipal bonds, high yield bonds, commodities, currencies, REITs , treasury bonds, etc.

Some other advantages include availability of margin, options and short sales, techniques which are not part of my investing philosophy.

Positive ETF Development

The popularity of ETFs has exploded in the last few years. Now over $500 billon is invested in these investment products. The big three ETF providers are: Barclay's IShares, Vanguard and State Street. Lots of small niche ETF providers are also in this market and new ones are in the pipeline. There has been an intense price war which has been bringing down ETF costs substantially over the last couple of years. Let's just say that this is a very exciting time to invest in ETF portfolios and it is fantastic to see clients' overall portfolio costs going down!

Disadvantages of ETFs

The biggest disadvantage is that a commission needs to be paid to buy and sell an ETF. You definitely do not want to be dollar cost averaging (investing a set amount each month) small amounts into ETFs.

Negative ETF Development

ETFs have now become way too popular and have attracted some opportunistic companies selling pricier versions that seek higher returns by following offbeat and narrow indexes (anyone in the mood for an ETF tracking European drug companies or luxury-good stocks or agribusiness companies- trading symbol MOO?). These smaller companies also charge much higher management expenses which is the main advantage that ETFs have going for them.

What has also happened is that many hedge funds are now using ETFs to trade in and out of the market. We also see more day traders and individual investors getting carried away with them and betting on individual country ETFs (Chinese stocks tend to be a particular favorite) or other heavily concentrated indexes. This frequent trading in and out of ETF positions increases overall portfolio costs and everyone should know by now that there are no gurus out there who can consistently practice market timing. Russell Kinnel, research director of mutual-fund research at Morningstar, said in a recent report most "gimmicky funds forgo the biggest advantage of indexing: low costs".