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Primer On Exchange Traded Funds (ETFs)

Exchange Traded Funds - The Basics

The What

Exchange-traded funds (ETFs) are basically index funds that trade on exchanges. They are built like conventional mutual funds but are priced and traded like individual stocks. They were originally designed as a way for investors to gain exposure to broad market indices in a more convenient, stock-like way.

ETFs were developed in the early 90s as a way to invest in the securities of an index. ETF shares represent a basket of stocks or bonds. The investment company sponsoring the ETF develops a portfolio of securities and places it into a specially structured account; in exchange, it receives a block of shares (not unlike a fund's shares) of equal value. The investment company then sells those shares in the form of a single security to investors on the open market.

These days, a quick search on Morningstar yields over 1,200 different ETFs. And while most are still the traditional index fund type, there is a growing number of niche-market, leveraged and commodity ETFs. See future blogs on how not all ETF's are created equal for more.

The How

ETF shareholders receive a proportionate amount of any income, capital gains, or losses realized by the underlying portfolio. But in comparison to traditional open-end mutual funds, they are remarkable tax-efficient. The share prices are linked to the value of the underlying portfolios. However, an ETF's actual share price, however, is determined by market supply and demand, just like the price of an individual stock or bond. The difference is captured in a premium or discount to the Net Asset Value (NYSE:NAV) of the ETF which can be found pretty easily at many reputable financial sites.

A S&P 500 ETF, for example, is backed by a portfolio that invests in the stocks contained in the S&P 500 Index. ETFs are not limited to the U.S. stock markets, or even to the developed international stock markets. Investment companies have developed ETFs that represent various bond markets, non-U.S. indexes, and market sectors.

There have been a few filings for "actively managed" ETFs, but they have been slow to develop. Partly because, ETFs can only function properly if the contents of their underlying portfolios are continuously available to the market and many active managers prefer not to reveal daily portfolio changes in order to avoid front-running (a practice in which investors load up on shares of companies that large mutual funds purchase, thereby making the trades more costly for the fund firms), which can lower potential returns for fund investors.

Their Uniqueness

ETFs are different in that they trade on an exchange like a stock or bond while providing access to a diversified index portfolio through a single investment.

Some of their unique properties:

  • ETFs are traded on the open market where their prices respond quickly to market activity.
  • Stop and limit orders can be placed on ETFs, sell ETFs short, or buy ETFs on margin.
  • Trades in ETFs incur commissions and possibly other brokerage fees.
  • Generally, ETFs have low management fees.
  • ETFs typically provide high tax efficiency.

Some Not-So-Well Known ETF Risks

With the explosion of ETFs in recent years, so have the risk associated with them. And while ETFs have many advantages, let's first consider the disadvantages to see if they are a good fit for your portfolio. Not all ETFs are created equal. So evaluating them individually is critical. Here's a sampling of some well-known and not so well-known risks.

Country-specific risk
When buying specific country ETFs, watch out for country-specific risk. There are a number of factors that make up this risk. These include political risk and credit ratings. Many economies, especially some emerging markets, are also tied to the price of commodities. Will the recent run-up in commodities and emerging market stocks affect a country specific ETF like the Brazilian iShares ETF (NYSEARCA:EWZ)?

Allocations to specific countries (as opposed to broad international funds) require some care because of country-specific risks. Investors have been rushing to invest overseas without paying enough attention to the risks that they are taking on. While the Brazilian iShares ETF (EWZ) has provided tremendous gains over the past several years, there is a level of risk in Brazil that many investors simply do not understand.

If you do want international exposure in your portfolio, you're probably better off with a diversified international ETF. Diversification can minimize the impact of country-specific risks.

Tracking Error Risk
Most people buy ETFs in order to buy a particular index. But how well does your ETF actually track that underlying index?

Let's look at what happened in emerging markets in 2007. A couple of ETFs that track the MSCI Emerging Markets Index are the iShares (NYSEARCA:EEM) one and the Vanguard (NYSEARCA:VWO) one. Each takes different approaches to tracking this index. Vanguard uses full replication, meaning the fund buys every stock in the index in exactly the right weights. The iShares fund uses "representative sampling" to construct the fund. This involves investing in a representative sample of securities that collectively has an investment profile similar to the Underlying Index. Essentially, iShares uses computer algorithms to select a subset of the broader index it believes will track the index as a whole. At one point in 2007, the iShares fund held just 250 of the 750 stocks in the broader index.

Unfortunately, with all the volatility in emerging markets, the iShares fund had trouble tracking its benchmark. In contrast, Vanguard's fund stayed within about a percent of the index, iShares fell behind by 7% over the first six months of 2007 alone. They can recover, but generally, funds that do "representative sampling" have greater risk of tracking error than funds that fully replicate their index fully.

Spread Risk
Given that ETFs are bought and sold like stocks, spreads are a real issue.

Spreads are the difference between the price at which someone is willing to buy (the "bid") shares and the price at which someone is willing to sell (the "ask"). They exist in any traded security, including individual stocks and ETFs. Spreads represent essentially a fee for trading: You buy shares at the ask and sell them at the bid, so the bigger the "spread," the more money you lose on each trade.

Many factors impact the size of the spread on ETFs, including:
• The assets held by the ETF-the more the better
• The volume of trading in the ETF itself-the more the better
• The liquidity of the stocks or bonds the ETF holds-the more liquid the better
• Market conditions-the less volatility the better

Naming Risk
Are you sure you know what you're buying based on the name of the ETF? Some ETFs don't always hold the kinds of stocks you expect.

Let's look at the iShares MSCI Pacific Ex-Japan (NYSEARCA:EPP) fund. Based on its name, it sounds like a way to get access to the fast-growing Asian economies. However if you look at the portfolio's holdings, the fund is 66% invested in Australia and New Zealand, with less than 1% in Asian emerging markets.

Just like a car, be sure to look under the hood before buying.

Tax Risk
For the most part, ETFs are more tax-efficient than competing mutual funds. But there are exceptions.

For one, ETFs tend to have higher nonqualified dividends than some mutual funds, so it pays to check the percentage of QDI a fund has had in the past before buying.

A bigger problem comes from new asset classes. One of the great things about ETFs is that they have opened up new markets to investors for the first time - commodities, currencies, and more. These newer asset classes are not taxed the same way as equities.

For instance, the SPDR Gold Fund (NYSEARCA:GLD) is one of the largest Gold ETFs around. It's also one of the cheapest and most liquid ways to buy gold. However, if you hold GLD for two years, and it appreciates 50%, what do you pay in taxes when you sell? The 15% long-term capital gains tax? Sorry, it's 28%, because the IRS considers gold a "collectible" that are taxed 28% regardless of how long you hold the funds.

Currencies and commodities have different but equally important tax issues. The more exotic the asset class, the more complex the tax issues become.

Counterparty Risk
Generally, buying an ETF is like buying a traditional mutual fund - you own a direct stake in the stocks or bonds that make up the fund.

Levered funds such as ProShares and some commodity funds have slight counterparty risk because of their use of swaps to construct their portfolios.

Let's not forget exchange-traded notes, ETNs. They are promissory notes underwritten by a bank. If that bank goes under, you end up as a creditor looking for pennies on the dollar. So you have to weigh the probability of the particular bank going away. And since ETNs can be redeemed from the issuer on either a daily or weekly basis, and are traded on the stock exchange intraday, you're unlikely to be caught out if you're paying attention. But still, if the last few years have taught us anything it's that anything is possible…just ask the folks from Lehman Brothers.