ETF Update: Ditch Mutual Fund Fees, CEF Buy Opportunities, ETF Futures, iBoxx High Yield Bond Fund

Includes: HYG, LGI, QQQ, SPY
by: Tom Lydon

Topics included in this update: Mutual Fund Fees, CEF Buy Opportunities, ETF Futures, iBoxx High Yield Fund.

Ditch Mutual Fund Fees

ETFs are often touted for having lower expenses than mutual funds. Of course, both fund types have administrative costs for the funds maintenance. However, actively-managed mutual funds have additional fees attached to pay for a fund manager. The fee tends to be anywhere from 0.50% to 1.0% of fund assets each year, according to Amanda B. Kish for The Motley Fool.

These fees can vary even greater than that though, depending on the type of mutual fund. For example, fees for international funds are typically higher than fees for domestic funds. ETFs passively track indexes without a fund manager involved.

Mutual funds also have 12b-1 fees, which allow funds to pay for marketing and distribution directly out of the fund's assets. This was set up in the 1980s to help funds attract new assets. But there are funds that are closed to new investors and still charge a 12b-1 fee. There might be some reform coming soon, but it is important to know that this fee can be tagged onto a mutual fund.

So without a fund manager and without 12b-1 fees, ETFs tend to have lower fees than mutual funds. Some low-fee, broad-market ETFs to consider include the SPDRs (NYSEARCA:SPY) at 0.8% and PowerShares QQQ (QQQQ) at 0.2%.

CEF Buy Opportunities

Although most CEFs have been affected by the market volatility and credit crunch like ETFs, some CEFs might provide investors with buying opportunities.

Unlike ETFs, CEFs have a set number of shares. So, depending on investor demand or lack of demand, they can trade at above or below their net asset value [NAV]. CEFs typically trade slightly below their NAV, but during the past few frantic weeks, the median discount for all CEFs widened to 6.5% as of Aug. 20, according to research firm Lipper Inc. These increased discounts are wonderful news for investors looking to use the market turbulence to their advantage.

For example, the Lazard Global Total Return & Income Fund (NYSE:LGI), which invests in stocks and foreign currency, is trading at a discount of about 12% to its NAV, report Lyneka Little and Shefali Anand for the Wall Street Journal. However, the fund has 35% of its assets in foreign-currency and debt markets, which makes it a potentially risky investment.

Besides the benefit of some CEFs having larger-than-normal discounts, there's also the chance that some smaller CEFs could liquidate or merge with open-end funds that don't trade on an exchange. This also would be good news to investors because the liquidation must be done at the fund's NAV, which is guaranteed to be higher than the current discount price of the fund. That translates into an instant windfall for investors.

ETF Futures

ETFs are investment vehicles that resemble mutual funds but trade like stocks and have been around since 1993. Stock-index futures were first introduced through the Chicago Mercantile Exchange [CME] in 1997. Since then, volume has increased on a yearly basis. As of 2007, there are three different futures contracts traded on ETFs, reports Hank King for Investopedia. They are:

  • Standard & Poor's 500 depositary receipts (tracks large-cap stocks)
  • Nasdaq-100 Index tracking stock (tracks Nasdaq's top 100 non-financial stocks)
  • iShares Russell 200 index fund (tracks small-cap stocks)

Below, King gives some ways to tell ETFs apart from futures on ETFs:

  • ETFs trade in shares, which are ownership in a trust or portfolio. Futures on ETFs trade in contracts of 100 shares that represent a legally-binding agreement to buy or sell the future at an agreed upon price at a future date.
  • ETFs do not have settlement dates. Futures on ETFs have sellers that deliver the underlying ETF shares to the buyer at expiration. Any futures on ETFs contracts that are offset before expiration are cash-settled.
  • ETFs require investors to have a securities account. Futures on ETFs require investors to have a futures account.
  • ETFs settlement occurs three business days after the trade date. Futures on ETFs are market-to-market daily, which means it is examined to ensure margin (borrowed money that is used to purchase securities) requirements are met.
  • ETFs are regulated by the SEC. Futures on ETFs are regulated by the Commodity Futures Trading Commission and the SEC.

iBoxx High Yield Fund

To minimize the risk associated with high-yield bonds (also known as junk bonds), investors might want to consider an ETF with diversified holdings. High-yield bonds are considered especially risky because there's a strong chance they could default. However, the positive side associated with these investments is that they have the potential for higher returns. One such high-yield bond ETF is the iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG).

HYG tracks the iBoxx $ Liquid High Yield Index, which is a corporate bond market index compiled by the International Index Company, according to Zoe Van Schyndel for The Motley Fool.

This ETF launched in April and has 50 bonds that are fairly equally distributed with a weighting of about 2% each. This ETF has an expense ratio of 0.5% and is currently down 5.5% for the last three months. Again, because HYG is a riskier investment, investors need to ensure it matches their financial goals.

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