With the low volume in U.S. securities trading, onset by the declining dollar and plunging economy, investors are looking for alternative financial vehicles. Exchange-traded funds, or ETFs, are fast becoming that vehicle of choice.
ETFs have doubled in popularity since the market meltdown; although they have been around since the 1990s. According to a Barron’s report on ETF growth, “[d]uring the past 12 months [of 2010], ETF assets shot up by more than 30%, hitting nearly $1 trillion. That’s rapidly gaining on the $5 trillion now invested in stock mutual funds, a total that grew only about 8% in the past year.” Additionally, this growth “accounts for 25% of the volume on U.S. exchanges.”
An exchange-traded fund is similar to stocks in the sense that they can be traded throughout the day and its value closely resemble their “underlying assets” but differs because instead of being an individual security certificate, ETFs are a collective basket of security certificates. ETFs are also comparable to mutual funds. Like mutual funds, they are an index of assets and they pay dividends in the form of additional shares. However, where they differ is that mutual funds are “a pool of funds” while ETFs are “a pool of stocks”.
|Stocks||Trade on an exchange||Stocks: Represented as owner of corporation
ETFs: Represented as owner of portfolio of assets
|Mutual Funds||Basket of assets||Cannot sell mutual funds short|
However, one important detail to make is that unlike stocks or mutual funds where any level of investor can purchase, ETFs are mostly traded by large institutional or retail investors. While the average investor is able to trade with them, it is not encouraged by most to do so because of the large number of trades involved in order to reap the full benefits. For example, “Exchange-traded funds make more sense for investors who invest a large lump sum or whose regular [monthly] deposits per fund are above $1,000,” as explained by the Yahoo! Finance education center. Moreover, “For substantial purchases, [the] transaction fee is an insignificant percentage, but for small purchases it becomes unreasonable. Investors are encouraged to save until they can invest at least $1,000 per ETF trade.”
Another point to clear up is how some investment resources will suggest using what is called the “dollar-cost averaging” method- which is what is described above- but as explained this is not an appropriate method to use if the investor simply doesn’t have $1000 to invest each month; the typical figure given in many “how to invest” examples is a minimum value of $10,000.
In fact, William Baldwin, an investment strategist for Forbes advises that one should invest in multiple ETF funds (as many as six) in order to diversify the spread of cost, taxes and losses, if any.
The risks involved with ETFs are based on the underlying assets from the particular class of assets. Exchange-traded funds come in many categories. There are funds for each sector of the U.S. economy, international funds, funds based on commodities such as agriculture, oil and gas, and gold, currency funds, real estate and bond funds, funds based on asset allocations, and lastly, funds based on class size and type. So, more risk would rest in classes such as technology, real estate or emerging markets than in some of the other classes. There are plenty of funds to choose from, thus, a well diversified portfolio can significantly reduce its risks.
Finally, more research into ETFs needs to be further conducted in order to understand its true nature. In a new report released by the Kauffman Foundation, a renowned non-profit organization devoted to entrepreneurship, stated that ETFs are economically unjustifiable derivatives that in turn create a systematic risk to U.S. financial markets and calling them “the proverbial tail that wags the market”.
- It’s Easy To Villify ETFs When You’re Loose With The Facts (forbes.com)
- How To Reduce Taxes On ETF Gains (blogs.forbes.com)
- Active ETFs: The Next Big Thing — or the Next Big Bust? (dailyfinance.com)