ETF Trading Explained

In recent years a relatively unknown investment fund known as an Exchange Traded Funds, or ETFs, have burst onto the scene.  Modern ETFs emerged in 1993 with the creation of  Standard & Poor’s Depositary Receipts or SPDR (spiders) that originally tracked the S&P 500.  ETFs have since evolved to the point where there are now over 900 separate ETFs tracking all sectors of the economy.  Acting similarly to traditional mutual funds, ETFs are created to track and mirror indices from all areas of investment including stocks and bonds to commodities and currencies.  However, unlike mutual funds ETFs are allowed to trade freely during trading hours like shares of common stock.  For both retail and institutional investors, ETFs could be a very attractive investment vehicle for many reasons, including providing the diversification of tracking large index or mutual funds coupled with the trading flexibility and liquidity of stocks.

Now to understand how and why an ETF is traded and what its benefits are it is important to understand the purpose of a mutual fund and how it is put together and traded.  Mutual funds work by taking deposits from investors and issuing that investor shares of the Net Asset Value of the particular firm, then taking that deposit and purchasing the securities that fund or index tracks.  The goal of mutual funds and ETFs is to achieve something called diversification.  This is achieved by purchasing a mix of securities so that the risk associated with that portfolio is as low as possible.  This method of investing provides many advantages over regular stock investing, but also includes many costs that need to be considered.  Because mutual funds can only trade at the end of the day there are some additional costs associated with that fund.  These costs include liquidity costs from the bid-ask spreads, cash drag caused by the movement of money in and out of the fund, and rebalancing costs due to corporate actions like mergers of spinoffs.

Investors have long enjoyed the diversification and risk protection offered by mutual funds, but with the surge in ETFs and ETF trading some investors are beginning to rethinking their investment strategies.  The process of investing in an ETF differs significantly from mutual funds.  The big difference is that large investors do not actually buy shares of the ETF, instead they supply a portfolio of stocks that matches the targeted index and is then incorporated into the ETF.  And when the investor wants to redeem their investment they receive a similar block of shares, that the investor can then sell for cash effectively eliminating the liquidity cost and cash drag that mutual funds experience when cashing-out their investors.  Additionally, ETFs offer some major advantages over mutual funds in terms of the tax implications of your investment.  The main advantage come from the fact that capital gains for mutual funds are incurred every time a purchase or sale takes place, whereas with an ETF the capital gains taxes are only incurred when the whole investment is sold.

The advantages offered by ETFs are significant, however for some investors they may not be the smartest investment.  For example smaller retail  investors  are forced to purchase the shares necessary to join the ETF on the secondary market where brokerage fees and costs may negate some or all of the cost advantages of owning the ETF.  Additionally, because ETFs trade continuously like stocks there can occasionally be a small difference between the value of the ETF and the stocks that it is comprised of, but the difference is usually equalized with a cash plug to the investor.

As the use of ETFs continues to grow some disadvantages are slowly coming to light that investors need to be aware of.  Along with the growth of ETFs that track major indices and funds, ETFs that track exocit investments like in emerging markets or currencies that don’t trade frequently have  been shown to be subjected to larger tracking errors than mutual funds that track similar assets.  Additionally, the sheer number of ETFs that have emerged over the last decade has led to a number of funds that track untested indices which could lead unwary investors into seriously risky investments.

As investors continue to flock to existing ETFs and new ones are created it is important to keep a level head and make sure that ETF trading is right for you.  Even though ETFs offer some marked advantages over traditional mutual funds does not mean that ETFs are right for everyone.  Making the decision to invest in an ETF, or any investment instrument, is not to be taken without a lot of thought and consideration and if possible the advice of financial professionals.  With the explosive growth in ETF trading volume and available ETFs, investors have a new and powerful tool to execute their trading strategies.