What are Exchange Traded Funds

What are Exchange Traded Funds or ETFs?

ETFs, short for Exchange Traded Funds are baskets of securities made up of any number of assets including stocks, bonds, futures, commodities and so on that are traded, like individual stocks. The ETF’s behave like stocks and currently all trade on the American Stock Exchange.

Unlike regular open-end mutual funds, ETFs can be bought and sold intra-day (and throughout the trading day).

More similar to stocks in some respects they can also be sold short and bought on margin. Unlike mutual funds which can be bought and sold with no transaction fees one pays a commission to trade ETF’s (e.g., $7 for Scottrade).

ETF’s or Exchange Traded Funds are usually more tax efficient, then normal mutual funds and possess lower annual expenses then even the least costly index mutual funds.

Example of SPDR State Street Global Advisory’s SPY Trust ETF

 

SPDR® S&P 500 ETF (SPY)
SPDR® S&P 500 ETF (SPY) Source: Morningstar

ETFs are essentially passively managed funds (unlike mutual funds that are “actively” managed), that allow investors to trade a portfolio of securities in a single transaction. They offer investors efficient trading of style-specific index, sector, and/or international exposure.

The index funds in particular replicate such indexes such as the S&P, Russell, Dow Jones and various international indexes. The specific investment style of an ETF can represent a specific sector or industry such as technology, a broad market index such as the S&P 500, or an international region or specific country such as Brazil or France.

In addition, various funds may focus on differing investment styles such as value or growth

How does an ETF work?

Although ETFs are more flexible than mutual funds, they can be traded on an exchange throughout the day, but unlike regular mutual funds, ETFs do not necessarily trade at the net asset values of their underlying holdings.

Instead, the market price of an ETF is determined by forces of supply and demand for the ETF shares, which in turn are driven by the underlying values of their portfolios. ETFs can trade at prices above or below the value of their underlying portfolios.

Advantages of trading with Exchange Traded Funds

  • Offers broad scope – wide variety of asset classes available to trade
  • Cost efficiency – are often lower than traditional mutual funds
  • No early redemption penalties
  • No minimum investment amount needed (just enough to buy a single share)
  • Can buy and sell as often as one wishes without fear of being barred from investment family
  • Global – ETFs can be bought and sold for almost all countries and/or international regions throughout the world
  • Tax efficiency – More tax efficient then actively managed mutual funds because they don’t have to sell underlying securities to meet redemptions. Distributions occur less often than with mutual funds
  • Consistent style – ETF’s don’t change styles or wander to different areas as some mutual funds do
  • Can be traded intraday – at prices throughout the – No settlement period like mutual funds
  • Are not susceptible to the kind of trading abuses uncovered in the mutual fund industry as of late (since Fall 2003)

Disadvantages of trading Exchange Traded Funds

  • Liquidity – Some ETF’s are thinly traded with low trading volumes, thus settlement prices can be of concern
  • Bid/ask spread issues: Can be of concern in volatile and thinly traded issues because of the way ETFs are structured. Sometimes ETFs are bought at a premium to the portfolio’s value and/or sold at a discount
  • Transaction costs – treated like stocks with brokerage fees assessed
  • Sometimes poor at tracking the underlying portfolio or markets they are based upon

How to use or trade Exchange Traded Funds?

ETF’s exhibit an ability to move up and down the ranks rather quickly at times somewhat like to the Fidelity Select funds. Their average volatility is also somewhat similar to the Fidelity Select funds.

Model portfolio results should be realistic in that they can be followed with end of day pricing trades.  ETF funds like stocks can be traded intra-day and have no settlement delays unlike mutual funds.

Since there are no redemption penalties to worry about, nor fears of expulsion from fund families, trading thresholds were set tighter with these funds. The top 10 (top 13.5%) was used as the trading threshold.

Like the regular Fund-Track model portfolios they uses a bi-weekly review and upgrading approach (Tuesdays and Fridays). The Multi-fund model portfolio holds 3 funds at a time.

The upgrading rules used for both Model portfolios are:

  • Upgrade a fund when it drops out of the top 10 OR
  • Its average price strength has dropped below 0% OR
  • It has dropped in price over 5%. (stop loss sell)
  • If general market conditions are bearish– As indicated by the top 20% average strength less than 0.0%
  • Never buy into negative price strength