ETFs: Investing for the 21st century
It has been consistently demonstrated that your investment returns aren’t so much a function of what stocks your invested in, but what sectors/asset classes your invested in. In the dot com boom, it didn’t matter what dot com stock you invested in, if you were invested in dot com companies, you probably did alright. During the dot com bust, it wasn’t just a couple select companies that went down, it was just about all of them. Because of this tendency for similar stocks to move together, it is much more productive to be able to simply buy ” or short – a type of stock, then try and nail the exact right company. But how can you gain exposure to a sector without taking unnecessary risk based on the company?
ETF. The latest all important acronym to add to your vocabulary. ETF stands for exchange traded fund; a relatively recent innovation that allows investors to directly target sectors for investment, instead of picking individual stocks, and praying those stocks wont underperform their sector. ETFs are similar to mutual funds, with a couple important differences. They can be bought and sold like a stock, no minimum investment or redemption fees, and you can short them.
ETFs can focus on certain regions; China for instance, is represented by the FXI. ETFs can focus on certain sectors; Those playing financial stocks may find XLF interesting. It can even focus on certain capitalizations; Those wanting diversification across small cap companies can make a single investment in IWM.
One question remains; why should an investor choose an ETF over a mutual fund. After all, mutual funds have professional managers whose sole responsibility is the management of money. Surely these investment professionals are the best place to go for excess returns? Well there are a couple downsides to mutual funds that aren’t experienced by ETFs. First off, there are slight tax advantages for ETFs compared to mutual funds. Should a large sell of occur in a mutual fund, the mutual fund has to sell its holdings, and incur capital gains to be paid by the remaining holders of the mutual fund. Due to how ETFs are set up, this cannot occur, and so you only pay capital gains when you sell (or cover) your position.
Another advantage held by ETFs is their great convenience over their mutual counterparts. Many mutual funds have redemptions fees if you exit within 30 days, whereas ETFs aren’t plagued by this problem. Also, unlike mutual funds, you can go short an ETF, benefiting from a fall in a sector instead of a rise. ETFs can also be bought and sold any time during the trading day, using limit orders, stop losses, and all the other tools you can use for buying stock.
Another important consideration is that most of the more liquid ETFs are optionable. This means that option-savvy investors can harness the power of stock options to change the risk-reward profile of their positions, and risk-conscious investors can use stratagems such as the covered call and protective put to protect their investment.
When investing in ETFs, its important to consider how exactly that ETF works. This can usually be found with a quick google search. While most ETFs attain their returns simply by holding the underlying securities, other ETFs use more exotic means to match their benchmark/investment objective, sometimes with varying success. Particularly important is the differentiation between an ETF and an ETN. ETNs are debt based investments, similar to bonds in some ways, and so their value is also partially dependent on the issuer. For this reason, investments in ETNs should be approached with caution, especially in the current, credit-tight market.
ETFs are a powerful tool for both the intelligent investor, and the active trader. Their ability to hone in and diversify within a given industry, or region of the world is invaluable when riding the larger megatrends that happen periodically in investment. Similarly, the ability to trade them just like a stock, using techniques such as shorting, options, and the various order types make them an invaluable asset for the active trader. For those believing the efficient market hypothesis, they even allow passive index investing at a cost far below that of a mutual fund.