From the March 2013 issue of Futures Magazine • Subscribe!

ETF Guide: ET-what? A primer on exchange-traded products

Click here for Futures' 2013 ETF Guide.

Two decades ago, State Street Bank introduced the SPDR S&P 500 to the market and the first exchange-traded fund (ETF) was born. Now, 20 years later, traders have their pick of more than 1,400 ETFs, along with various other exchange-traded products (ETPs).

ETPs can offer many advantages to traders, notably diversity, ease of use and cost-effectiveness. But before adding these products to their portfolios, traders also should be aware of the corresponding risks. Here, industry experts offer an overview of the products that fall within this asset class, and some common pros and cons of trading them.

In simplest terms, ETFs are securities that track the performance of an underlying index or asset. Traders who buy ETFs own shares of a pool of securities, and, in the event that the company managing the fund goes out of business, those traders still own those securities. Although they would have to find a new manager for their ETFs — or liquidate them altogether — they will not lose their investment.

One of the greatest strengths of ETFs is their sheer variety. There are ETFs covering almost every asset class and market sector — from commodities to forex and equities — and traders can use them for numerous purposes.

“They can be used for retirement, income generation, speculation, for any purpose and any opinion the customer may have,” says George Fischer, director of product management at E*Trade. “They’re simple and easy to understand. So certainly they offer the simplicity and availability to open an account and use it for a variety of different purposes.”

Traders who are lacking exposure to a specific asset class can remedy that problem easily by buying an ETF that comprises stocks from various companies within that sector.

This approach also can help to reduce risk because traders own shares in multiple companies. “You’re not taking a [position] on any one particular company, but you do want exposure to the sector to help control the risk in your portfolio,” says Michael Iachini, managing director of ETF research at Charles Schwab. “And you can take examples like that from any part of the market, whether that’s bonds or stocks or individual countries or parts of the commodities market, too.”

ETFs are especially helpful if traders want to invest in a market sector that lies outside their expertise. A trader looking for more exposure to Chinese stocks, for instance, simply can buy an ETF comprising shares of multiple Chinese businesses rather than researching individual companies, Iachini says.

Aside from their ease of use, ETFs also are affordable, says Michael Burke, vice president of client training and education at TradeStation. Although the price of ETFs can vary, many fall within the $10 to $50 range.

They also can be traded intraday, unlike mutual funds, which are priced only once at the end of each day. To take advantage of this, traders should divide their trading days to avoid the times at the beginning and end of the day when the volatility curve is highest, advises Eric Pollackov, managing director of ETFs for Charles Schwab. “We try to eliminate [the high volatility curve], and I try to advise clients to trade intraday from 10 a.m. to 3 p.m. ET, because volatility creates uncertainty and uncertainty creates wider markets and wider markets create poor executions for investors,” he says.

Finally, because of the way in which they are structured, many ETFs are more tax-efficient than mutual funds. ETFs generally are subject to capital gains taxes only if the entire investment is sold, while mutual funds incur these taxes for in-kind transactions.

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