ETF Update: Indexing Debate, ETF Pros and Cons, CEFs Defined, Gold Attracts

Topics in this update include: Indexing Debate, ETF Pros and Cons, CEFs Defined, Gold Attracts.

ETF Indexing Debate
In the investment world, there are two sides to indexing, and lately the proliferation of ETFs has spurred this controversy further. Traditionalists are long-time supporters of the market-cap weighted index, where companies are valued by their total market capitalization. The 21st century's fundamental indexing approach has proliferated with the success of many ETFs utilizing this structure. Fundamental indexing weighs companies on factors other than market capitalization, such as dividends, sales, profits, etc.

Jeffrey S. Coons for Investment News says this argument has resulted in a past-performance debate instead of focusing on the essential question: "Are investors able to achieve returns adequate to compensate for the risks of owning stocks?"

If acquiring returns adequate to the risk taken is the goal, then the fundamental indexing approach tends to come out ahead. However, market-cap weighted index proponents say fundamental indexing is nothing more than an actively managed approach to indexing, which defeats the purpose of ETFs tracking an index. As the debate continues, investors are left to make up their own minds and decide what works best for their portfolio.

ETF Pros and Cons
ETFs' benefits include high liquidity, transparency and intraday trading. However, these advantages can be disadvantages at times. For example, the convenience of intraday trading that stocks and ETFs share costs investors commission fees. Depending on how often investors trade, fees can accumulate, thus reducing their investment's performance, says John Devcic for Forbes.

Another potential drawback is underlying fluctuations. Diversification is a great trademark of ETFs, but that doesn't offer complete protection from volatility. Granted, the more diversified an ETF portfolio the less volatility will affect it. This highlights why its vital for investors to know what's in their ETFs. Liquidity is another benefit that can be a problem when ETFs are thinly traded. If there's a large gap between the bid and ask price, it could be a sign that its an illiquid ETF. Looking at the assets under management for a particular ETF can also give investors an idea of its liquidity: If it's high, it's probably OK.

More often than not, ETFs do not distribute capital gains; however, they can and there are a few that do, which means shareholders are responsible for paying the capital gains tax. Finally, another snafu that investors can run into with ETFs is whether to use a cost averaging strategy or a lump sum. If investors use the dollar-cost averaging strategy, (which is investing a little bit each week, month, year, etc.), it can become costly because investors will have to pay commissions every time.

These are all issues to keep in mind, but the benefits of ETFs still outweigh their disadvantages.

CEFs Defined
A closed-end fund can look almost identical to an ETF to the novice investor. A closed-end fund can be bought and sold throughout the day just as an ETF can, but that is where the similarities end, reports Tim Middleton for MSN Money. Originally, closed-end funds were created to satisfy demand among sophisticated investors who wanted a specialized investment vehicle to enhance their portfolios. In other words, closed-end funds tend to be for advanced students while ETFs are for investors of all levels. So how can one tell the difference between the two?

The main difference between the two types of funds is in the pricing and the portfolio structure. In general, ETFs are more transparent and cheaper than closed-end funds. Closed-end funds' holdings are rarely disclosed and they trade either at a premium (above its net asset value) or a discount (below its net asset value). Another sign that you're dealing with a closed-end fund is if there is little or no published information on it.

Before getting into closed-end funds, make sure you've studied them thoroughly and that they fit with your investment strategy.

Gold Attracts
With the dollar in decline, gold ETFs are looking, well, like a golden investment opportunity. Gold is generally considered a safe investment whenever the dollar's value decreases. Also, with the markets as crazy as they are lately, it becomes even more attractive, says Jim Wiandt for Index Universe.

For those looking to invest in gold ETFs, a few options are available:

• streetTracks Gold Shares Fund (GLD) - up 5.4% year-to-date
• iShares Comex Gold Trust (IAU) - up 4.8% year-to-date
• PowerShares DB Gold (DGL) - down 0.6% for the last three months as it was launched in early 2007. It invests in gold futures not the bullion.
• Market Vectors Gold Miners ETF (GDX)- down 4.7% year-to-date