How To’s in Purchasing Exchange-traded Funds

As far as purchasing ETF shares, the easiest question to handle is “where do I buy?” In this respect, ETFs are no different than standard stock purchasing, and any stockbroker can sell an exchange traded fund. And from there, it all gets more complex.

First thing to remember: Purchasing ETFs never involves cash.

Investing in an ETF begins with the creation unit, the smallest possible collection of ETF stock; the creation unit can consist of between 10,000 to 600,000 shares (according to the U.S. Securities and Exchange Commission, the figure is typically 50,000) that will serve to underpin the ETF. Because of these creation units, ETF shares can be traded intraday. Representing a small piece of the creation unit, ETFs are issued to the prospective dealer as an in-kind trade involving the swapping of securities, ultimately assisting in tax relief.

The actual size of the creation unit makes it virtually impossible for even large private investors, and investment institutions typically purchasing and selling the units. Such firms purchase creation units with securities that parallel the portfolio of the ETF. Once the ETF creation unit is purchased, it is broken up into smaller parcels; private investors can then buy shares at exchange at the market price, with lot size variable.

Remember: Selling ETFs never involves cash. When a creation unit is “sold,” what is in actuality returned to the seller is a securities portfolio composed holdings is identical ratio to the ETF; the seller is actually trading the ETF shares for the like actual securities. The ETF’s status as non-liquid assets is the most crucial difference between exchange traded funds and mutual funds.

The purchase of ETF shares also requires careful consideration with regard to a prospectus. Playing by the rules of an individual investment company, each ETF carries a prospectus; this prospectus is only guaranteed to the purchaser of creation units, however, and only some ETFs supply share purchasers. In these cases, a “product description” must be provided, which acts as an ETF summary.

One contention commonly held against ETF investment is the possibility that these funds will be traded at a share price that is not connected with the value of the underlying securities. This is where arbitrage comes in, a system which provides further insurance for the private investment.

Take the value of the ETF to be amount X, representing the total of the net worth of all individual securities within the ETF. The investor should be expected to pay X for one share of the ETF. However, the ETF need not be traded at value X at all; and if the ETF trades at some figure over X, those buying ETF shares at that price are paying more than the individual securities are worth; the whole would be less than the sums of the parts.

The ETF arbitrage system seeks to set this potential abuse right. The trading price of the ETF is set at the close of trading every day along with all other sorts of mutual funds. When the total of underlying share values do not balance with the ETF pricing, arbitrage results. If the securities are priced lower, arbitragers purchase the securities in question and then parlay them into creation units; they can then sell shares in the creation unit on the open market. If the ETF shares are priced lower, arbitragers purchase the securities from the open market. The theory is that arbiter action restores the supply / demand balance so that the ETF values themselves are harmonized. This system has worked since nearly the genesis of modern ETFs and was instituted by institutional investors before shares in exchange traded funds were even available to private investors; a steady balance has been maintained since the 1990s

With its myriad advantages, the exchanged traded fund looks like a winner for the beginning, conservative or laissez-faire investor. There is one outstanding drawback to the ETF, a comment made anywhere ETF investment advice is given: High agency commissions. The trickiest – and enthusiasts would swear the only tricky – part of ETF investment is avoidance of these commissions.

One way typically used by the ETF investor is merely to use a 401(k) or IRA scheme to base the portfolio in, thus directing investment into a mutual fund company and allowing the investor to pay taxes rather than commissions, almost always at a favorable rate. Assuming the tax rate paid on returns is lower than the commissions (and it typically will be), returns are automatically higher. In the much quoted and highly illustrative example on investment website Morningstar.com, that company’s estimates show that, using figures from the S&P 500 index, a $10,000 investment would require an average of two years to see return on investment. The 401 (k) / IRA option is already used in the Vanguard Target Retirement funds, hoping to increase investor confidence in making ETFs a part of retirement 401(k) plans and open the market to investors of all sizes and investment interests.

The challenge for all ETF issuers right now is in fact to draw in the small investor market, making ETFs both an option for more and well-known by more. The London Stock Exchange announced that the ETF Securities Fund will see release in the second quarter of 2006, part of the LSE gamble to bring small investors into the fold. ETF Securities is a combination of a wide range of commodities, including copper, oil, silver and zinc. While German, American and British investment brokers feature a number of mixed commodity index funds, the ETF Securities fund is specifically promised to require smaller capital investment to earn returns on investment.

As far as immediate costs, traditional mutual funds look more appealing at first glance, what with no sales charge. However, the fees in mutual funds do add up, as annual management fees tend to be significantly higher than those of ETFs. In the medium term, the gamble of the mutual fund becomes more apparent, as trading of mutual funds can only happen based on the closing price at trading day’s end. In a single bad day, mutual funds can take a hit of several percentage points, while the intraday trading nature of ETFs allow the sharp-eyed and attentive plenty of time to bail out in a hurry if necessary.

You can certainly buy a mutual fund directly from a fund group at no sales charge. Annual management fees will typically be higher with a traditional mutual fund and you can only buy or sell at the closing price at the end of the day. There are tradeoffs in each of the two types of funds.

Traditional mutual funds often appeal to the small investor simply because they represent more familiar ground to him or her; after all, mutual funds have been around for most people’s entire lifetime now, whereas ETFs were born in the 1990s, remain a burgeoning phenomenon, and are unknown in detail to a great deal of small-scale market players. Mutual funds can earn big money quickly and quite a few of them consistently outperform the markets themselves. Working against mutual funds here, though, are numerous data and independent research that reveals the risks inherent in mutual funds, namely that the chance that a star mutual funds beats the market next year is pretty much 50/50, regardless of prior results or consecutive years profitable. ETFs win again in terms of security.

At the heart of all indexing is whether most investors should attempt to beat markets by stock picking. First of all, the question presupposes that a mutual fund that has outperformed a market in the past will continue to do so in the future. Numerous studies by unbiased university researchers have shown that star mutual funds are just as likely to underperform than outperform the market several years into the future. Many investors have concluded that they are better off not taking the risk and instead remain happy with market returns of an index fund. Next, actively managed funds inevitably have higher annual management fees and have a worse capital gains tax profile. Finally, investors cannot get in or out of traditional mutual funds instantly with a known price as they can with an ETF.

In the long term, the average ETF far outweighs the average mutual fund in returns. When demonstrating the opportunities inherent in exchange traded funds, Agile Investing presents their projections of the performance of a typical ETF against that of a like typical mutual fund. Assuming an eight percent return for both on equal investments of $100,000 over twenty years, the 1% advantage in the ETF expense ratio alone results in additional returns of more than $75,000. And this figure doesn’t take the advantageous tax rates on ETFs, nor the possibility that the mutual fund in question is one of the majority that will actually underperform its benchmark index.

As far as the actual amount of the check you’ll have to write, ten thousand dollars, as shown above, is a decent start for the ETF investment; this, however, really only represents a minimum, especially because a single investment is recommended by just about every advisory source, and long-term investment is critical. Despite the typically high commission which must be paid out to institutional investors, the truth is that the Standard’s & Poor 500 (to cite one example) brings higher returns than 80% of managed funds, given enough time to mature.

It cannot be stated enough: Patience is the mightiest of all virtues in exchange traded fund investment.

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