Today we’re going in a slightly different direction. I will answer this frequently asked question. “Why do you like and write so much about Exchange Traded Funds?” Fair question. Keep in mind that technically, an ETF is a Mutual Fund that trades on an exchange.
Let’s begin why I like ETFs.
First, because of lower transaction costs, total expense ratios and differences in distributions, ETFs historically have lower total fees than their cousin, open end mutual funds. Year over year this can make a huge difference in your total portfolio value. For example, if there is a 1 percent additional fee, when the market is on a multi-year bull run, investors may look the other way. Instead, if you have a 4 percent annual return and have an extra 1 percent fee, the fees are eating up 25 percent of your profits. This can make a huge difference even in a short time frame.
Second, when trading funds, I like to see what they are trading. While transparency is a popular buzz word these days, many times Wall Street falls short in this area. When owning a mutual fund, I can only see its holding four times a year and many times that information is delayed. Mutual Funds must disclose their holdings each quarter and after that they can be trading who knows what. When I own an ETF I can see their holdings daily. This is very important to many investors, like myself, who are sensitive to what I own. For example, I would not like to own funds that hold cigarette or liquor companies. I do not care how much money I can make with them.
Third, ETFs can be more tax efficient than mutual funds because ETF shares generally are redeemable “in-kind”. Purchase a mutual fund in the last week of the year that they sell long term profitable holdings and you may be subject to capital gains taxes. Do to the internal set up; ETFS may bypass this capital gains fiasco.
Four, ETFs trade on an exchange, thereby giving us very important data including volume. For chartists like me, volume shouts volumes, (pun intended). This data gives us many additional tools to help with our financial decisions. Mutual funds are not traded on an exchange and volume is not published. Since ETFs trade on an exchange their price changes throughout the day. In addition, ETFs can be purchased on margin and are available to be sold short.
Five, an ETF market price may trade at a premium or a discount to its underlying value. When this happens an AP, Authorized Participant, can buy or sell the ETF to get it back to its fair value.
Six, ETFs can be used as hedging vehicles by trading options on ETFs.
Finally, there is no such thing as a perfect security. One can suffer a very large downfall trading the very volatile and dangerous volatility funds in addition to leverage funds that are both weapons of financial destruction for many. I have found this out first hand — trust me!
There are many different types of ETFs available for traders and investors. Next week, I will list the different types and give examples of each.
DAVID O. ENGLAND is the founder of the Eye on the Market-Training Academy, and retired associate professor of Finance. He can be reached at firstname.lastname@example.org. The information above is for educational purposes only and is not intended to be financial advice. Your decision to buy, sell, short or hold any stock or investment product is a direct result of your own decision, free will and research.