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William J. Lynott Are Exchange-Traded Funds Right for You? T
HE PAINFUL volatility of today’s stock market is making it more difficult than ever for the average inves- tor to decide how, where, or if to invest. Still, history and conven- tional wisdom continue to insist that equity investments are one of the safest and most profitable places to put your money over the long term. Perhaps that’s why Exchange-Traded Funds (ETFs), which were introduced nearly two decades ago, are continuing to grow in popularity. Assets that are under ETF management now exceed $1 trillion.
ETFs are a form of mutual fund with several important differ- ences. As the name suggests, ETFs are traded on the stock exchanges just as individual se- curities are. As with stocks, they undergo published price changes throughout the trading day as they are bought and sold. And as is the case with stocks, you may buy or sell any number of shares for the current market price. While buyers of regular mutual funds have to wait until the following day to learn precisely how many shares they have bought, and at what price, buyers or sellers of ETFs have the same immediate access to that information as do buyers and sellers of stocks. Another important advantage that ETFs have over regular mu- tual funds is lower costs. Both ETFs and regular mutual funds
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carry built-in management fees, but those fees are usually lower for ETFs than for similar mutual funds. For instance, the Vanguard Standard & Poor’s 500 ETF car- ries a cost of 0.06 percent per year, while the same company’s S&P 500 index fund carries a cost of 0.17 percent (although if you invest in the gold-plated ver- sion, Admiral Shares, of the fund, which requires a minimum invest- ment of $10,000, the cost drops back to 0.06 percent). The first ETFs were passively managed funds that tracked an index such as S&P 500 or Total Stock Market Index. One of the original ETFs, offered by the State Street Global Advisors since 1993, is called the Spider after its name, SPDR, which is an acronym for Standard and Poor’s
Depository Receipts. Among the most popular of all ETFs, the Spider, which trades under the symbol SPY, tracks the S&P 500 index.
The landscape of the ETF mar-
ket changed in February 2008 when the US Securities and Ex- change Commission started to authorize the sale of actively managed ETFs. That authoriza- tion greatly expanded the range of ETFs available to investors, although a large majority of the more than 1,000 ETFs available for purchase continue to be pas- sively managed. Many of these funds still track the major market
indexes across a wide range of sectors or industries, but many are more narrowly focused on individual sectors or strategies. While everyone’s investment situation is different, the wide va- riety of ETFs now available can help to fill almost any portfolio need. An investor with a portfolio consisting entirely of US stocks could easily dip a toe into the foreign equities market at a rela- tively low cost by buying an ETF limited to foreign equities. Another example would be a portfolio consisting mainly or en- tirely of corporate bonds. The pur- chase of a single bond market ETF could greatly improve diver- sity at minimal expense by in- cluding such investments as Treasuries, mortgage-backed bonds, and TIPS (Treasury Infla- tion-Protected Securities). When you buy or sell an ETF, you may have to pay a commis- sion to your broker just as you do in a stock or bond transac- tion. However, a price war be- tween major brokerage houses that are looking to capture the growing ETF market has dropped those commissions as low as zero. The price war began in No- vember 2009, when the Charles Schwab brokerage house made a trendsetting announcement: It would completely eliminate com- missions for online purchases or sales of any of the eleven ETFs that it offers.
Another major player, Fidelity, was quick to respond. Starting in February 2010, it waived all of its commissions for online trades of any of the thirty iShares-brand ETFs it offers and committed to keeping those commissions at zero at least until 2013. Vanguard later joined in the fray by waiving commissions on its own house- brand ETFs, and then TD Ameritrade upped the ante by offering more than one hundred ETFs from many different com- panies at no commission, with the provision that the buyer had to hold the ETF shares for at least thirty days.
This trend toward zero com-
missions makes ETFs even more attractive, especially for investors who practice dollar-cost averag- ing—the practice of investing a fixed amount on a regular basis regardless of market ups and downs. Zero-commission offers have also made it less costly to invest in ETFs than in conven- tional index funds, most of which still carry full brokerage house commissions.
While lower investment costs are an important reason to con- sider making a place for ETFs in your portfolio, that alone isn’t suf- ficient reason to choose them in preference to other forms of in- vestment. Before you put your money in ETFs, you should do your homework, just as you would for any other investment. ■
D E C E M B E R 2 0 1 1 / J A N U A R Y 2 0 1 2
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