From the July 01, 2009 issue of Futures Magazine • Subscribe!

ABCs of ETFs

Unless you’ve been living on another planet, you know that exchange-traded funds (ETF) are one of the fastest growing investment vehicles today.

Like mutual funds, ETFs give professional and individual investors (including those of more moderate means) the opportunity to own a share in a diversified pool of assets. Unlike mutual funds, ETFs trade like a stock on a stock exchange and can be bought or sold throughout the day through a broker-dealer.

The first ETF, the Standard & Poor’s Depositary Receipts or SPDR, premiered in 1993. Although other funds soon followed, growth was slow at first. ETFs really started to gain momentum around 1997. However, over the last five years, assets under management have more than tripled, growing from approximately $150 billion at the end of 2003 to nearly $500 billion at the close of 2008. In 2007, assets hit the $600 billion mark before the current economic crisis took its cut of the ETF market.

ETF activity is very much on the upswing. The Investment Company Institute, the D.C.-based association that represents U.S. investment companies, reports that, as of April 2009, the combined assets of the 726 U.S. ETFs rose to $529.66 billion. April assets grew 9.9% ($47.6 billion) over March 2009 (see, “Heading back north”).

You can easily get a sense of the depth and breadth of the marketplace today by scrolling though the Exchange-Traded Funds Center on Yahoo! Finance where you’ll find data for more than 800 ETFs that cover practically every asset class imaginable. There are funds for every major index (Dow-Jones, S&P, Nasdaq) and sector of the equities markets (large cap, small cap, growth, value). There are international, regional and country-specific funds. In addition, there are fixed income funds and funds for precious metals, natural resources, technology, utilities, healthcare, transportation and communications. The list goes on and on. While some of the commodity and hedged ETFs are viewed today as hybrids, Ivers Riley, the man who helped create the products, says that was the plan all along.

ETFs are popular because they are flexible and because they combine the easy diversification, low expense ratios and tax efficiency of index funds with the features of ordinary stocks, like limit orders, short selling and options.

Because ETF shares can be economically acquired, held and disposed of, many investors treat them as long-term investments and use them for asset allocation purposes. Others trade shares frequently to implement market timing strategies.

Laurie Berke, principal of the Tabb Group, points out that fund managers also use ETFs to manage cash flows. As money flows into and out of mutual funds, an ETF that tracks the underlying portfolio can be the best way to manage that cash day-to-day, instead of trading in and out of the securities. “In international markets especially,” Berke says, “ETFs can be a less expensive alternative to trading and settling each of the individual securities in the local market, because bid/ask spreads can be wide and settlement risk can be high.”

CONSTRUCTING AN ETF

ETFs originate when a fund “sponsor” determines an investment objective. The sponsor, or manager, chooses a target index for the ETF, selects the basket of securities that will comprise the fund and decides how many shares should be offered to investors. The manager submits an operational plan to the SEC for approval.

The sponsor usually doesn’t own the securities, so it enters into participation agreements with other entities (often institutional investors or securities firms) that actually do own the securities. In return for providing the securities, the ETF sponsor issues “creation units” to the participating entities. These units typically represent ownership of 50,000 to 100,000 fund shares.

The creation unit holders can opt to keep their shares or sell them on the open market. The shares they decide to sell are listed on stock exchanges like NYSE and Nasdaq, where investors can purchase them through a broker-dealer. Retail investors who buy interests in an ETF don’t really own an interest in the portfolio, but instead own a share of the creation unit.

ETFs are organic, so as changes are made to the underlying index, (a stock is added or dropped) the creation unit holders are required to make changes to the basket of securities originally deposited in the fund. This ensures that the fund continues to properly track the composition of the index.

Like a mutual fund, the broad market exposure provided by the ETF is one of its most appealing features. As Darrell Jobman, senior analyst with TraderPlanet.com notes, investors want to be in the market, but some can be intimidated by having to decide which stocks they want to own. There are those who don’t feel confident about their ability to make these decisions. “Other investors simply don’t trust the accuracy of the information they get from companies. The ETF model relieves the pressure a bit,” says Jobman.

An ETF also can be an effective diversifier, no matter what an investor’s asset allocation objectives. A portfolio with a 70% stock and 30% bond asset allocation can easily be created using ETFs. This portfolio could be further diversified by dividing the stock portion into large-cap and small-cap value stocks and the bond portion into mid-term and short-term bonds. And now that ETFs are fulfilling their original vision — with products based on a range of commodities, currencies and using leverage and active management — investors can configure a truly diversified portfolio.

Ownership costs are low because of the ETF’s efficient product structure. Ongoing costs can be lower than comparable actively managed mutual funds and, in some cases, lower than index mutual funds. Some fund sponsors have actually established expense caps to make ownership costs clear and straightforward. Ordinary brokerage commissions do apply, but they can be pretty economical for the buy-and-hold set and there are certainly discount brokerages out there.

Tax savvy investors appreciate ETFs for their tax efficiency. ETF shareholders can defer most capital gains until they sell their shares. And the ETF’s structure also allows it to manage its taxable positions in a way that reduces the risk of capital gains distributions to shareholders.

ETFs are priced continuously, and unlike traditional mutual funds that are priced at the close of the markets each day, investors can buy or sell their shares throughout the day at the current offering price. They can be purchased using the same order types investors use for stocks, including stop loss and limit orders.

STYLES ARE CHANGING

The shift from a traditional passive management approach to an actively managed one seems to be gaining momentum. Ed McRedmond, senior vice president, Portfolio Strategies with Invesco PowerShares Capital Management, sees the evolution as inevitable and believes there are lots of investors who’d prefer to outperform the market, not merely track it. “Not taking full advantage of the efficiencies inherent in ETFs doesn’t make sense,” says McRedmond. “The ETF is a delivery vehicle for an investment. In addition to index-based ETFs, why not let a professional portfolio manager, using all of the tools at their disposal, select the stocks that have investment merit for the ETF. Let’s use the ETF structure to its fullest potential for both passive and active investments.”

Laura Oatney is a freelance writer with more than 20 years of industry experience. She can be contacted at loatney@yahoo.com

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