What You Need to Know About Exchange-traded Fund Investment

As an investment, ETFs potentially promise the best of two worlds within stock market trading. ETFs offer the diversification and relative security inherent in an actively managed mutual fund while also allowing investors the freedom to buy and sell ETF shares just as he or she can buy and sell the stock of a publicly traded company. ETFs also feature a few distinctive advantages, with the typical ETF carrying low expense ratios, low turnover, and an advantageous tax structure. Since the ETF is a relatively new phenomenon, and since so many ETFs are able to take advantage of technological advances and trends in e-commerce, innovations come fairly frequently to the market.

Though the jury is still out on whether the typically high commission which must be paid out to institutional investors, the truth is that statistics show that the Standard’s & Poor 500 brings higher returns than 80% of managed funds.

Most ETFs have a noticeably lower expense ratio than mutual funds. The ETF expense ratio almost never tops 1%, while rates of 0.1% are common; mutual funds can be 3% or more.

In America, the typical ETF is more tax efficient than mutual funds in many areas. Under U.S. tax law, when a mutual fund achieves a capital gain that is not balanced by a loss, the mutual fund is required to distribute capital gains to shareholders by the end of the quarter. This happens when large fluctuations strike the index, usually when a panic occurs and a large volume of stock is pulled from the index. Said gains are taxable to shareholders, whether reinvesting in further fund shares or not. The ETF, meanwhile, is not redeemed by the stockholders and investors are allowed to merely sell in open trading. The result is investors realizing capital gains only when they choose to sell their own shares.

Indeed, ETFs are often chosen because of their features similar to stock. Trading with ETFs can take place in essentially the same fashion as shares in the stock market, with options to buy on margin, limit order, sell short or use a stop-loss order at the ETF investor’s disposal. None of these freedoms are offered with a mutual fund. In open-end funds, investors can sell only at the closing price of the mutual fund. Stop-loss orders basically become irrelevant and the ETF investor is much less at the whim of stock market flights of fancy. ETFs are priced throughout the day and heavy losses can be avoided by the vigilant.

The argument against ETF investment is mainly all about commissions, but these can be avoided and/or softened. When using a 401(k) or IRA scheme to base a portfolio in, a direct investment into a mutual fund company allows the investor to pay taxes rather than commissions.

Paths to success in ETF investment are surprisingly simple and number three. First, of course, is the above-mentioned tax hedge. Assuming the tax rate paid on returns is lower than the commissions (and it typically will be), returns are automatically higher. Should dealing with the ETF directly not be desirable and a broker must be used, much research and consideration should be put into the decision, period. Online investment website Morningstar.com breaks it down like so. Using the S&P 500 index as basis, Morningstar experts calculate that a $10,000 investment requires an average of two years to see return on investment; this suggests the following two keys to profit in ETF investment.

Number two on the list of rules essential to success is the investment amount. Ten thousand dollars, as shown above, is a decent start for the ETF investment. Note the use of “the” in the preceding sentence: A single investment is strongly recommended as well for, again, commissions will kill or seriously forestall returns on investment.

Last but not least is the easiest of all: Leave it alone. ETF trading is intraday, which in itself implies that trading activity is slow and very deliberate. Indeed, the creation of the ETF certainly had long-term investment in mind.

However, the disadvantage of ETF investment can prove to be exactly the opposite to the right kind of investor. Those that prefer a laissez-faire attitude to investment should find ETFs one of the most attractive opportunities out there. ETFs are perfect for those wanting to, as an old infomercial used to say, “set it and forget it.”

Most exchange trust funds carry one of three legal structures. Open-end index fund refers to a fund structure registered under the SEC Investment Company Act of 1940 which reinvests dividends. Dividends are paid quarterly, and derivative and loan securities are permissible for use in the open-end index fund.

The unit investment trust is also registered under the SEC Investment Company Act of 1940 and pays dividends quarterly; dividends are not reinvested in a unit investment trust, however.

The grantor trust is a fund structure that pays dividends directly; it also offers investors an advantage in its voting rights within the fund’s securities. The grantor trust is not registered under the SEC Investment Company Act of 1940 and is mostly known for its use in the Merrill Lynch HOLDRs.

The most widely held ETF today is the Standard & Poor’s Depository Receipt, a format with origins in the very first ETF ever traded in the United States. Other ETFs are tied in with the Dow Jones Industrial Average or the Nasdaq 100 index; these are known as “diamonds” and “qubes,” respectively. Diamonds, qubes and SPDRs are unit investment trusts.

Open-end index funds known as “iShares” are exchange-traded securities composed of more than sixty index funds. The funds are compiled by an index provider from among Cohen & Steers Capital Management, Inc.; Dow Jones & Company; the Frank Russell Company; Goldman, Sachs & Company; Morgan Stanley Capital International, Inc.; the Nasdaq stock market; and Standard & Poor’s. The iShares schemes listed below are distributed by broker / dealer SEI Investments Distribution Co. with Barclays Global Fund Advisors serving in advisory capacity.

In terms of assets at the conclusion of year 2005, the list of top-ranked American ETFs includes the following.

The DIAMONDS Trust (Series 1) is unit investment trust in Dow Jones Industrial Average equity securities and thus reflect that index provider’s price and yield. DIAMONDS is distributed by broker / dealer ALPS Distributors, Inc.

iShares are extremely popular, as evidenced by their prominence in this list. the iShares Dow Jones Select Dividend Index Fund is the most successful of all; this one is tied in with the Dow Jones Select Dividend Index, a group of one hundred high yield securities. The Dow Jones Select Dividend Index is in turn a broad index of the total U.S. equity security market.

Blessed with easy to understand names, the iShares MSCI EAFE Index Fund, the iShares MSCI Emerging Markets Index Fund, the iShares MSCI Japan Index Fund, the iShares Russell 2000 Index Fund and the iShares Standard & Poor’s 500 Index Fund are all named for the index on which investment rules are based.

MidCap spiders (or Standard & Poor Depository Receipts) investment returns are based on the performance of the S&P Midcap 400 Composite Price Index and in actuality represent co-ownership in the MidCap SPDR Trust (Series 1). Sector SPDRs, despite their status as unit investment trusts, are open-end funds concerned with separate industry groups within the S&P 500. The most heavily traded ETF, Qubes are tied in with the Nasdaq 100 index and are thus heavily dependent on the technology industry.

State Street Global Advisors manages an ETF group known as streetTRACKS. streetTRACKS is based on a multitude of indices from the Dow Jones global market to Morgan Stanley Dean Witter’s technology indices.

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