Exchange-traded funds are a form of mutual fund which combine the instant pricing of stocks with the diversification of a mutual fund. Here are some frequently asked questions about ETFs that may help:
Frequently Asked Questions about ETFs
Q: Where and how do I buy them?
Buy them as you would any stock, at any brokerage firm.
Q: Why would I buy an ETF when I can get an index mutual fund without a broker?
You can certainly buy a mutual fund directly from a fund group at no “load” or sales charge. Annual management fees will typically be higher with a traditional mutual fund and you can only buy or sell at the closing price at the end of the day.
Q: Why would I try to match the market with an index fund when I can beat it with an outperforming mutual fund?
First of all, the question presupposes that a mutual fund that has outperformed a market in the past will continue to do so in the future. Numerous studies by unbiased university researchers have shown clearly that mutual funds with leading performance records are just as likely to underperform than outperform the market several years into the future. Many investors have concluded that they are better off not taking the risk and instead remain happy with guaranteed average market returns of an index fund. Second, actively managed funds inevitably have higher annual management fees and have a worse capital gains tax profile.
Q: Are there any Dow Jones Industrials or S & P 500 ETFs?
Yes, there are numerous funds that track these and other popular indexes. Remember that Dow Jones and Standard & Poor’s maintain their respective indexes, and that fund groups license the indexes so that more than one fund can end up tracking an index.
Q: Are ETFs guaranteed or insured?
There seems to be little risk of abuse of the ETF structure as an investment vehicle. In the US the Securities Exchange Commission thoroughly examines any application to create an ETF, and only large and closely watched firms are allowed in on the creation and redemption process of an ETF certificate. Finally, the same government agency (the Depository Trust Clearing Corporation) that ensures that individual stock certificates end up in the right investor’s hands after a trade also ensures the ETF certificates are assigned correctly in a trade. In a decade of trading billions of dollars worth of ETFs, to our knowledge no US investor has ever lost money from fraudulent ETFs.
The risk of the underlying asset is quite another matter. Each asset class must be examined separately, and risk profiles of assets may change over time. Stocks are clearly risky, and ones in technology or emerging markets particularly so. Long-term bonds and real estate are also risky in their own way. Short-term investment grade bonds, however, have generally proven quite safe.
Q: Are ETFs only for stocks?
By no means. Any class of asset that has a published index around it and is liquid can be made into an ETF. Bonds, real estate are available now, and and gold ETFs are due in late 2003.
Q: Are there international ETFs?
There are many, including regional funds such as European or Pacific Rim funds, as well as individual country funds in relatively well-developed economies. In each of these countries there is an established index of reasonably large and liquid stocks that allows this to happen. As developing nations stabilize their stock markets, they will no doubt adopt ETFs.
Q: Do any ETFs try to beat the market?
Eventually there should be actively managed ETFs, but operationally it is much more difficult to manage. Applications to the SEC for such funds have been made but to date have not been successful. The problem is that an ETF is easier to create and redeem when all players in the process know exactly what basket of stocks will go into it. By its very nature, an actively managed fund must be secretive, because to reveal to the world what a stock fund is buying at the moment exposes it to parasitical traders who can jump in first and resell the stock to the eager fund. Various schemes have been proposed to circumvent these and other problems.
Q: Can non-US citizens own them?
ETFs are available in most developed nations. In the US, anyone who can open a brokerage account and buy stocks will be able to buy ETFs.
Q: Is it possible ETFs are just a fad?
This is not likely. As of July 2003 ETF assets in the US topped $155 Billion and are still growing in double digits, far faster than traditional mutual funds.
A type of mutual fund. Like ETFs, closed-end funds differ from open-end mutual funds in that they trade throughout the day over an exchange. Unlike ETFs, however, they have no mechanism to prevent them from trading at substantial premiums or discounts to their net asset values.
The fee you pay a broker to buy or sell a security, such as a stock or an ETF, for your account. The charge is typically assessed on a per-trade basis. You do not need to pay a commission to buy or sell no-load, open-end mutual funds, giving them a cost-advantage over ETFs for investors who plan to invest regular sums of money or who trade frequently.
The smallest block of ETF shares that can be bought or sold from the fund company at net asset value, usually 50,000. These are only bought and sold “in-kind.” For example, when you sell one, you receive a portfolio of securities that approximates the ETF’s holdings, not cash. Creation units’ size means that only market makers and institutions can afford to buy or sell them. All other investors can buy or sell ETF shares in any size lot at the market price, rather than at NAV, over an exchange.
Shares in an ETF, Diamonds Trust Series I, that track the Dow Jones Industrial Average. The fund is structured as a unit investment trust.
|Discount to NAV
Unlike regular open-end mutual funds, which are bought and sold directly from the fund company at the net asset value (NAV) of their portfolio securities, ETFs and closed-end funds trade at prices determined by the market forces of supply and demand. A fund that trades at a price less than its NAV is said to trade at a discount to its NAV.
|Exchange-traded fund (ETF)
The broad class of funds, excluding closed-end funds, which trade throughout the day over an exchange. ETFs have low annual expenses, but you must pay commissions to trade them. ETFs do not redeem shares for cash, and thus do not need to sell securities (possibly realizing capital gains) to pay investors who redeem their shares. They are typically more tax-efficient than mutual funds. Unlike closed-end funds, ETFs market prices usually closely track their NAVs. Most ETFs are index funds.
The annual fee that all funds or ETFs charge their shareholders, expressed as a percentage of the fund’s average daily net assets. This ratio includes such items as the management fee, trustee’s fee, license fee, and 12b-1 fee, among others. It does not include the commissions you must pay to buy and sell ETF shares, or the costs incurred by the fund in trading its securities. HOLDRS do not express their fees as expense ratios, but instead charge a flat quarterly fee per 100 shares.
A group of ETFs advised and marketed by Barclays Global Investors. iShares are structured as open-end mutual funds.
Holding company depository receipts, a type of ETF marketed by Merrill Lynch. Unlike other ETFs, HOLDRS can only be bought and sold in 100-share increments. HOLDRS do not have creation units like other ETFs, but investors may exchange 100 shares of a HOLDR for its underlying stocks at any time. Existing HOLDRS focus on narrow industry groups. Each initially owns 20 stocks, but they are unmanaged, and so can become more concentrated due to mergers, or the disparate performance of their holdings.
The total return of an ETF based on its market price at the beginning and end of the holding period. This may be different from the ETF’s NAV return. The market return is the return actually earned by ETF investors, except for those who hold creation units.
The price of an ETF as determined by the market forces of supply and demand. Unlike regular open-end mutual funds, which are always bought and sold at NAV, the market price may differ from NAV. Most ETFs typically trade at market prices near their NAVs.
|Net asset value (NAV)
The value of each share of a fund as determined by the value of its underlying holdings, including any cash in the portfolio. NAV is calculated by dividing a fund’s total net assets by its number of shares outstanding. Shares in regular open-end mutual funds are bought and sold at NAV, but shares in ETFs (with the exception of creation units) are bought and sold at the market price, which can differ from NAV.
The total return of an ETF, based on its NAV at the beginning and end of the holding period. This may be different from the ETF’s market return. The market return, not the NAV return, is the return actually earned by ETF investors, except for those who hold creation units.
The typical mutual-fund structure, and one used by several groups of ETFs, including iShares and Select Sector Spiders. This structure allows the funds to reinvest their dividends immediately, which could permit them to hold slightly less cash than ETFs that are structured as unit investment trusts.
|Premium to NAV
Unlike regular open-end mutual funds, which are bought and sold directly from the fund company at the net asset value (NAV) of their portfolio securities, ETFs and closed-end funds trade at prices determined by the market forces of supply and demand. A fund that trades at a price higher than its NAV is said to trade at a premium to its NAV.
The Nasdaq-100 tracking stock, an ETF that tracks the technology-laden Nasdaq-100 index. The popular name, Qubes, derives from the ETF’s ticker symbol, QQQ. Qubes are structured as unit investment trusts. Qubes are by far the most heavily traded ETF.
SPDRs, or Standard & Poors’ Depository Receipts. A group of ETFs that track a variety of Standard & Poors’ indexes. SPDR Trust, Series 1, usually referred to as “Spiders,” tracks the S&P 500 index. Select Sector SPDRs track various sector indices that carve up the S&P 500 index into separate industry groups. SPDR Trust, Series 1 is structured as a unit investment trust, but Select Sector SPDRs are open-end funds.
A group of ETFs managed by State Street Global Advisors. These ETFs track various indexes, including Dow Jones style-specific and global indexes, technology indexes from Morgan Stanley Dean Witter, and the Wilshire REIT index. StreetTracks are open-end funds, not unit investment trusts, and trade on the American Stock Exchange.
|Unit investment trust
A structure used by some ETFs. One important difference between this format and the open-end fund format is that the latter allows ETFs to reinvest dividends immediately, while the former does not. This could result in ETFs that use the unit investment trust structure having a slight cash drag on their performance.
Vanguard Index Participation Receipts: ETF versions of Vanguard index funds. VIPERs are structured as share classes of existing open-end funds.