I’m cross-posting this from another board since I need all the input I can get.
I’m pretty much a financial beginner, or dum-dum if you will. I’m not happy about the poopy level to which interest rates have sunk, and have been moving bits and pieces of money into mutual funds.
Now I’m trying to understand what these exchange-traded funds are all about. A little of what I’ve been told is sinking in. Can someone set me straight if I’m not grasping it correctly? Here’s what I get so far:
ETFs are traded all day, and the price per share changes all day, just like a stock. A mutual fund’s price only changes once per day, a couple of hours after the market closes, when the prices of all its holdings are calculated out.
ETFs are cheaper to manage than a mutual fund. They have no highly-paid manager per se, just flunkies to direct the funds according to the pre-set dictates of its goals.
Unlike a mutual fund, there are no minimums. You could buy a only couple of hundred bucks’ worth if you want.
Do I have some of the basics? What other differences, good or bad, can you add?
Because ETFs trade on an exchange, every time you buy or sell shares, I think you’ll have to pay a trading commission. If, instead, you purchase the mutual fund equivalent (e.g., the Vanguard 500 Index Fund instead of the S&P 500 SPDR ETF), you will not, generally, pay commissions, if you buy the mutual fund directly from Vanguard.
Index mutual funds (e.g., Vanguard S&P 500) have very low expense ratios as they are passively managed (a computer program automatically buys and sells stocks to keep the fund in alignment with the underlying index). The most important difference between and index fund and an ETF that follows the same index is the ability to sell during the day. You can call the mutual fund company to sell at any time, but they only execute the transaction at the end of the next trading day, and at that day’s closing price (or closing index level). With an ETF, you can sell in “real time” and get the price at whatever time of day you sell, provided the exchange is open.
Why is this important? Usually, it’s not. But, if markets are dropping and you want to liquidate your position quickly, having to wait until the end of the day could cost you a lot of money.
This is how they first came to my attention. During one of these last massive stock market dives, I overheard one of my bosses discussing ETFs. He bought, at a very low point in the market, many shares of UltraDow30, an ETF index fund. Of course, the market began to recover and is still recovering; he sold in a few days and made, to judge by his gleeful giggling over the phone, a respectable bit of money.
Two things that may be worth considering. First, you should determine whether you are investing or speculating. What your boss did was speculating – in and out of the market (or specific investments) in a short time frame hoping to make a quick buck. If you are investing for the long term (e.g., for retirement 20+ years away), then attempting ‘market timing’ is ill-advised. Make regular contributions to an investment account, and don’t worry about short-term fluctuations.
Second, beware the “Vegas Effect”. No one comes home from Las Vegas bragging about how much money they lost. But win even a modest sum, and they brag to everyone. This gives the impression that everyone is winning. It’s the same with the stock market – you are unlikely to hear about the dozen times your boss lost money.
You may want to pick up a copy of “Investing for Dummies”. (No insult intended - it is part of the “for Dummies” series of books.) It is actually a good and highly readable introduction to the investing world.
Oh, I’m not insulted. That sounds like a good idea. Yeah, the more I study about ETFs, the more they sound like just a convenient tool for a day trader, which I am not. I’m thinking that I’ll just remember them as an option in the case of some future colossal market nose-dive (crossing myself).
I did move some sums recently into conservative Vanguard index funds. My laddered CDs were maturing, and the 1.5% offered for new CDs was just not floating my boat. So I diversified a little and am hoping to do a bit better. Wasn’t it nice two or three years ago when you could make 5.25% on CDs?
Just to point out, if you are getting 5.25% on a CD, you are actually getting ~ 1.25% due to inflation. Inflation is ~4% a year (historically) and just keep even you need to match inflation. Also, out of the 1.25% there are taxes which make the return even lower.
ETFs are nice in that they don’t have all the fees that go along with many mutual funds. Also, they have ETFs that track industries which is nice if you want to do some sector rotation.
I agree that for ultra short term and very long term investing, ETFs have the edge, due to easier tradeability in the first instance and very low fees in the second instance.
ETF’s take several years to recoup the brokers fees for trading it, compared to ultra low cost funds like Vanguard, and even then it takes several years after that before the advantage becomes worthwhile (as in, can give the average retiree enough for an extra restaurant meal a year :)) But if its not gonna be traded a whole lot and just sat on, it wouldnt be bad to look at.
As an aside: does anyone know anything about ETFs in hard to price markets such as foreign stocks and distressed bonds? That might be one way in which ETFs might have an advantage over some mutual funds, in hard to value markets, because the market will decide how much your ETF is worth rather than the mutual fund operator having to make an educated guess sometimes.
Also, IIRC, mutual funds have a habit of declaring capital gains near the end of the year, so even if you haven’t “sold” any of your holdings, you have to pay tax that year.
I’ve always heard that ETFs had lower costs than “active” mutual funds – via Sharebuilder my monthly investment ($1400) costs me $8 (it’s $4 per trade, but I buy two stocks, one of which is an ETF). On the selling side, it’s $10 for each sale. The difference is that the $4 purchase is made on the same day each month, whenever they think it’s the right time to buy (on that day), whereas when I sell I’m using real-time trades. Mutual funds, in addition to the capital gains issue, have expense loads that are almost always higher than those involved with ETFs. (Most ETFs that I buy, such as GLD and SPY, could be little 50-line computer programs; I assume mutual funds only get competitive with that when the funds are defined to be maintained with the same (low) level of complexity.
This is not a commercial for Sharebuilder, but they take money out of my checking account each month and sell me fractional shares (i.e., my $700 purchase, which is really $696 after their fee, may purchase me 8.15 shares of GLD. They keep track of the fractions, and (this perplexes me) they can do automatic dividend reinvestments. So … last month they added 0.252 shares of PG when PG paid their dividend, and I did not incur a fee at all.
For an investor such as myself (i.e., lazy), the automatic monthly purchase is easy to deal with, given that I don’t deal with it at all.
I’ve recently started considering a TIPS (Treasury Insurance-Protected Securities) ETF (named TIP, coincidentally) – this is supposed to be low risk investment (to maintain one’s money, not to strike jackpots), but I’m still trying to figure out exactly how they act.
It’s worth pointing out the difference between Closed End ETFs and Index ETFs.
A Closed End Fund is similar to a mutual fund in that there is a manager with a specific, unique goal for the fund. The manager’s objective for the fund might be to identify and purchase undervalued small cap biotech companies, for example. Unless there is another offering, the fund will always have the same number of shares outstanding and trading on the exchange. Due to this, liquidity can become an issue. There can be wild fluctuations in the relative price of the fund vs. the Net Asset Value (NAV) of the actual assets. An egregious example as of right now would be the Cornerstone Total Return Fund which is trading 73% higher than the value of the actual “stuff” the fund owns.
Index ETFs suffer less from this issue due to index arbitrageurs. By definition, an index ETF’s goal is to return the exact same as its underlying index. For most of the major indexes, and many of the minor indexes, there are a variety of traded products that follow the same benchmark. Look at the S&P 500 SPDR ETF. This ETF is meant to provide the return of the S&P 500 index. Imagine that SPY were to become irrationally priced and trade at a premium. If this were to happen, there would be an opportunity for arbitrage owing to the law of one price. An arbitrageur could simultaneously purchase a basket of all the individual stocks in the S&P 500, while selling short the same amount of the SPY ETF. Assuming a reversion to the mean (a decline in SPY’s premium to the actual index), the arbitrageur would then sell the stocks and buy in his short position in the ETF. This type of arbitrage can be carried out amongst individual stocks, ETFs, futures, swaps, options, etc.
The reason for premiums/discounts in closed end ETFs could sometimes be attributed to the absence of a suitable product to “arb” against. That isn’t to say that they are bad products. On average, I’d expect them to be quite efficiently priced. But, it’s something to keep in mind.