- Exchange traded funds (ETFs) are powerful investment vehicles for diversification, cost, preservation of capital and trading. Exchange traded funds have grown rapidly to cover most broad investment purchases and many niche markets. Regularly traded index funds for the Dow Jones Industrial Average (DIA), the Standard & Poor (SPY) and the Nasdaq (QQQQ) are all examples of exchange traded funds. Market participants use these etf's for hedging, liquidity, market direction and option trading activity. Etf's attract both investors and traders who do not wish to make individual stock selections but only capture the broad movement of the market.
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A sponsor, usually a major bank such as Barclay's, will create a plan for an investment vehicle to very large institutional buyers as a test of interest. If the reception for such a new vehicle is strong, the bank or investment bank will purchase the necessary portfolio of stocks (after registering the new issue on a major exchange and the Securities and Exchange Commission) and deposit them with a trustee. The trustee will then keep the securities and give the bank ETF certificates (which are like certificates of participation) for the securities sold. The bank or broker will then market the new securities to investors and make a market in the security. The broker makes money from the collection of stock sold into the trust and resold as an ETF. When the sale of the stock is made to the public, it is priced slightly above its liquidation value or net asset value. On an ongoing basis the investor makes money by becoming a market maker in the new
ETF. Each day shares are arbitraged (bought and sold) against the liquidation value of the shares. In addition, new shares can be bought to market at any time and sold to participating institutions or individuals. Typically less than .35 percent of the portfolio is liquidated to pay institutional expenses like the trustee and exchange and regulatory fees. These fees are apportioned on a daily basis and generally accrue quarterly. - Because the funds themselves are passive and tend to be arbitraged around net asset value, they have great cost advantages over fee-laden mutual funds where expenses are five to ten times more expensive. In addition, investors prefer ETFs because they allow investment in a wide range of stock asset classes. Most mutual funds invest in the same group of shares so that buying two stock mutual funds does not diversify you effectively. With exchange traded funds you can measure your own risk tolerance and identify asset classes that you are not yet invested in. Without knowledge of a particular market (imagine the difficulty investing in emerging markets) or not having found the proper vehicle by which to invest, ETFs may provide an entry for the uninitiated investor. Importantly for tax conscious investors, ETFs are tax efficient. They are immune from the tax consequences due to the accumulation of trading profits and losses on both a short term and long term basis that mutual funds suffer. It is important to remember that your ETF shares will trade in the free market, which may vary slightly from the net asset value of ETF. Internet resources in the Resources section give information regarding price and content of each ETF portfolio.
