Simply put, investment in exchange traded funds is recommended (and these days, usually highly recommended) for investors who wish to participate in day trading activity; wish to exercise their short selling option; wish to limit orders; wish to stop orders; wish to purchase shares on margin; and wish to accrue lower management fees. The ETF can at least match the mutual fund’s secure nature as well, while few of the above-mentioned advantages are even possible in mutual funds.
ETFs are based on indices, allowing full movement in the market; thanks to the continuous adjustments to ETF pricing throughout the trading day, such freedom of movement can be well taken advantage of. And an advantage that definitely works in favor of ETFs for the beginning investor is the excellent transparency offered in exchange traded funds; the investor with the most rudimentary of knowledge need not fear complicated composition or movement of his or her funds.
With its myriad advantages, the exchanged traded fund looks like a winner for the beginning, conservative or laissez-faire investor. As an offspring of the mutual fund, the ETF is subject to far less fluctuation than actively traded stock. As a successor to the index fund, the ETF requires even less care while offering greater stability than the mutual fund. And as a unique creation, the ETF affords the investor more options on short notice than in index funds.
Discounting the possibility of an especially dynamic market, the ETF will outperform most any market investment, the sole question is when. Rarely will the ETF win out in the short term, of course (though it has been known to happen in certain commodities), though basically the formula can be as simple as the longer the wait, the greater the return on investment.
When dealing with mutual funds, the first question is whether the fund in question which has perhaps outperformed the market even in the last quarter will continue to do so. Several university-researched studies have shown that any mutual fund has an equal chance of underperforming and outperforming in that market in subsequent years. Though less exciting, index funds are accordingly less volatile, and investors can bank on the simple market returns an index fund provides with little gambling.
As an investment, ETFs potentially offer the diversification and security of an actively managed mutual fund while also allowing investors more freedom, low expense ratios, low turnover, and an advantageous tax structure. And since the ETF is a relatively new phenomenon able to take advantage of technological advances and trends, innovations come fairly frequently to the market.
Because of the booming ever-expanding ETF market and the opportunities therein, private investors have adapted. ETFs are now often used as hedge funds; some consultants even advise that, for those wishing to change their short-term market position, exchange traded funds allow easy transference from one market sector to another. An increasing common strategy employed when changing asset managers is to sell an extant investment, plunk that money into an ETF; later the ETF is cashed in for reinvestment once the new asset manager is in place.
In hedging, ETFs are used to counter market downturns. Via short selling, ETF shares are borrowed and repaid once speculation on the stock market sees returns. Thanks to these new strategies in hedging, quite a few new ETFs now feature options, allowing buying and selling options along the lines of more traditional market maneuvering. In hedging small portfolios, the exchange traded fund is again quite excellent, due to the opportunity to buy and sell short and the fact that most derivative contracts are traded in larger denominations than ETFs are. Selling short gives the definitive advantage of shorting an exchange traded fund upon the news that components within a given ETF are falling or destined to fall.
The popularity of hedging with ETF has, like so many other aspect of ETF in general, caught on like wildfire: Over 75% of hedge funds are now based in exchange traded funds.
Adding a few ETFs to the portfolio can do more for it than just help with a little hedging. Exchange traded funds can color the portfolio with foreign investment opportunities (as the dollar has been weak for years, the Euro has made an excellent investment), can prevent a top-heavy aspect with too many large firms dominating investment holding, and can allow investment in a burgeoning field.
Another advantage frequently mentioned in discussion of exchange traded funds is the regulatory arbitrage system. Achieving a balance between the net worth of all individual securities within an ETF and the index itself is necessary for the ETF system, which would otherwise be open to untold abuse by those wishing to trade at advantageous and unfair prices.
The ETF arbitrage system sets this potential abuse right. Arbitrage results when the set trading price of the ETF does not balance out with the sum total of underlying share values. Arbitragers can purchase the securities in question and parlay them into creation units if securities are priced too low or they can then sell shares from the creation unit on open market. This arbiter action harmonizes ETF values to achieve the supply / demand balance once again. The system put in place by institutional investors has existed since the mid-1990s and a steady balance has been maintained since then, ensuring stable results.
In the ETF, too, the pricing system itself can make investors money. Because dividends must be paid out from a mutual fund investment, taxes must be paid on the capital gain; should gains prove low enough, an unfavorable tax rate could easily turn a slight profit into a sizable loss. The ETF, however, need not be redeemed (and therefore tax bills need not be received) until the investor chooses to sell, effectively giving another opportunity for tax hedging.
Even some seemingly fundamental problems in exchange traded funds have been solved recently. Until last year, most found ETF investment for retirement too costly a proposition; after all, the overwhelmingly most significant disadvantage in ETFs is the likelihood of egregious broker commissions. However, 2006 expects to see the release of ETFs designed for the retirement-minded investor with lower commissions, and software solutions only can alleviate much of the problem with extra expenses, which are mostly caused by overabundant investor movement.
In fact, retirement funds may actually prove to be two answers in one. Basing the ETF portfolio in an IRA or 40(k) scheme allows the investor to pay taxes rather than commissions, which almost always result in a favorable rate with a modicum of caution exercised. The 401(k)/IRA option is already used in the groundbreaking Vanguard Target Retirement funds, one of many ETF programs which hope to further open the market to investors of all sizes and investment interests. Today, pension plans involving exchange traded funds represent almost one-third of all such plans.
Another such fund of interest to those looking to get in on the ground floor with a minimum of risk is the soon to be released ETF Securities Fund from the London Stock Exchange. The ETF Securities Fund is a sort of trail blazer in the quest to interest more varied private investors in commodity investment. While investment brokers in locations all over the world 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.