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You’ve been hearing about Exchange Traded Funds (ETFs) emerging as the preferred managed money solution for investors. The growth of ETFs has been, and continues to be, tremendous among institutional and retail investors alike. Whether measured by daily trading volume, the number of annual new fund issuances or assets under management, ETFs have grown by leaps and bounds over the past decade. Why did the Assets under Management (AuM) in the global ETF market surge 41.5 percent in 2009? Why all this excitement surrounding ETFs?
ETFs essentially offer direct exposure to equity stock indexes, geographical regions, industries, commodities and currencies. Well, so do mutual funds, you would say. The difference is that ETFs combine some of the advantages of a mutual fund with the flexibility of a stock, for a fraction of the cost. But we are getting ahead of ourselves.
Let’s begin with what Exchange Traded Funds are. ETFs are funds that are traded on the stock exchange that reflect the underlying value of a basket of assets. The make up of the underlying basket of shares is designed for the ETF to track either a market index — say the FTSE500 — or sector indexes of the stock exchange. First developed as a tool to track stock market indexes, this investment tool has evolved into products that track commodities, real estate, currencies and derivatives.
Emergence of ETFs
The origin of ETFs can be traced back to 1989, when a proxy of the S&P 500, Index Participation Shares, was formed to trade on the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange. The next one to be launched, Toronto Index Participation Shares, began trading on the Toronto Stock Exchange (TSE) in 1990. Tracking the TSE 35 and subsequently the TSE 100 stocks, this ETF quickly gained popularity.
Since then, there has been no turning back for ETFs. Their popularity spiked with the turn of the century. According to a 2009 review of the global ETF industry by Barclays Global Investors, there were 1,635 ETFs, with $633.55 billion in assets, at the end of the first quarter. The AuM in US and European ETFs combined crossed the $1 trillion mark in 2009.
With their increasing acceptance among individual and institutional investors, the ETF market became fiercely competitive. AuM in the global ETF market is projected to cross the $2 trillion mark in 2011.
All That Glitters isn’t Gold; Rather Gold ETFs
A primary example of a successful new age ETF is Gold ETFs which are exchange traded funds that are backed by gold and track the gold price. The performance of gold ETFs has been exemplary over the past decade. This is because of the defensive characteristic of the precious metal.
The 3 most popular ETFs that offer exposure to gold or gold mining companies are SPDR Gold Trust (GLD), Market Vectors Gold Miners ETF (GDX) and ProShares Ultra Gold (UGL). In 2009 the year on year total return for each trust was 24.03 percent, 36.72 percent and 43.86 percent respectively.
How ETFs Work
For example, equity-tracking ETFs are funds that track the performance of a share index like the FTSE 500. How it works is that big investment managers who own real shares on the FTSE will deposit these shares with a trustee, in exchange for shares called creation units. These in turn are divided into individual shares in the ETF and sold to the general public in any quantity — even a single ETF share can be bought and sold. These shares are then traded on the market exactly like individual equities with its own ticker symbol.
ETFs differ primarily from traditional mutual funds in that they are not actively managed and are therefore not strategic, but are more similar to an index in the way they offer investment exposure. In addition, mutual funds do not trade during the day. While mutual funds take orders during the trading hours of the bourse, the transactions only take place when the market closes. The price of mutual funds is, therefore, the sum of the prices of all the stocks included in the fund when the market closes. In fact, mutual funds are sometimes traded weekly or even monthly. On the other hand, ETFs trade throughout the trading day, allowing investors to lock in a price for the underlying stocks. Lastly, investors can also set down Limit Orders, whereby they can advise their broker to purchase ETFs at or below a certain price.
ETFs are also said to be a cheaper option as mutual funds have managers who buy and sell shares (either to take a profit or cut losses). Thus, mutual funds are strategic — a manager makes asset allocations. In contrast, ETFs are passively managed diversified vehicles which results in substantially lower transaction costs for the investor.
Therefore by default, ETFS are usually a cheaper alternative than a mutual fund or unit trust as they are not actively managed.
Give Traditional Mutual Funds a Run for Their Money
Most investors prefer ETFs to traditional mutual funds because of 3 major factors.
Liquidity: compared to traditional mutual funds, ETFs offer the benefits of real-time tracking and real-time trading. Consequently, one can sell or buy ETFs, depending on the market condition, to either limit losses or to capitalize on favorable market trends.
Low costs: several mutual funds require investment minimums and levy early redemption fees. This is not the case with ETFs
Transparency: mutual funds are required by the authorities to disclose their holdings only periodically (usually once in every quarter). When you invest in an ETF, you know exactly what you own on any particular day.
ETF Risks: Can’t Have Your Cake and Eat it Too
ETFs do have numerous benefits. However, an investor must be aware of the drawbacks to make a sound investment decision. With ETFs, investors have to pay a brokerage commission each time a trade is made. If there is a lot of trading activity on a portfolio, the cost of trading could well offset the expense savings offered by the ETF as compared to mutual funds.
Another drawback of ETFs is that, as they trade on the market, they typically do not trade at their underlying net asset value (NAV), as the demand and supply for the said ETF will also influence its market value.
Lastly, as ETFs are passively managed, at most the performance of ETF will match that of the index or the performance of the underlying assets, minus the operating costs. On the other hand, a good mutual fund manager can add significant alpha (strategic decision making which enhances returns) and can therefore often significantly outperform any index.
The challenge then for maximising the savings from ETFs is that one should find a broker who offers a significant discount on the brokerage fee. Given their flexibility, low cost and tax benefits, ETFs tend to become a very critical component of an investor’s portfolio. ETFs are also great investment options for diversification. In fact, some investors focus on ETFs alone and build a diversified portfolio with only a few ETFs. It is worth remembering that if one’s primary interest in an ETF as an instant and cheap diversification tool, one should always pay particular attention to the underlying assets and sectors they represent.
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