You purchase ETFs just like any stock through your broker.  You can purchase them with market, limit, and stop orders, and you will pay a commission to buy or sell.  You can even sell ETFs short unlike mutual funds.  This allows you to use them for hedging strategies.  You can bet that a market sector or the entire market will drop in price for the commission price to short an individual stock.  However, an individual stock will be harder to predict since other factors such as a hostile takeover may raise the stock price.  These factors will not have as great an impact on the broader ETF fund holdings.  Additionally, many ETFs also have corresponding options.

You also have more control for tax purposes than with mutual funds.  You pay taxes on capital gains or losses when you sell your ETF, not when others sell.  In mutual funds, share sales by other investors will trigger capital gains or losses for you.

We do caution investors making small purchases or dollar cost averaging.  Broker commission costs will make ETFs expensive for small purchases.  Generally, ETFs are best when putting a large amount of money into an index fund all at once.  The cost of paying the commission will be saved over time by the lower annual expenses of these funds compared with mutual funds.

Why invest in Exchange Traded Funds (ETFs)?

ETFs offer the following major advantages:

1. Easy method to buy a diversified basket of stocks or bonds with lower annual expenses than most mutual funds.  You can trade an industry (sector), country, or broad stock indexes.

2. You buy and sell them just like stocks without the sizable discounts or premiums of closed end mutual funds.  You may place limit and stop orders, sell them short, and purchase or write options for most ETFs.

3. You have more control for tax purposes than with mutual funds.  You pay taxes on capital gains or losses when you sell your ETF, not when others sell.  In mutual funds, share sales by other investors will trigger income capital gains for you.

4. ETFs are not hurt by "market timers" who buy and sell rapidly.  The recent mutual fund scandals are not possible with ETFs, since investors can buy them at current prices and do not have to wait until the end of day, stale prices, like with mutual funds.

5. Over 300 funds are available and ETFs are growing rapidly.

6. You pay transaction costs directly.  They are not hidden like in mutual funds.  With mutual funds, the expense ratio typically does not include the funds transaction costs as they are usually listed in the fund's statement of additional information as a total dollar amount instead of a percent of assets.  This makes comparing expenses for mutual funds difficult.

Some common uses for ETF funds are:

• You believe a specific industry or country will be a good investment.  However, you don't know which company to buy.  For example, you think biotechnology will continue to grow, but don't want to gamble and buy only one of these stocks.  In this case, you can buy the NASDAQ Biotechnology Fund (IBB) which owns 73 stocks in this field.

• You have a technology stock in your portfolio that has lost you money.  You would like to sell it and take the tax loss, but you still feel that technology stocks will rise.  You can sell your individual stock, and buy one of the many different ETFs that focus on technology companies without triggering the wash sale tax rules. 

• You want to invest in the stock market generally, but don't know which area to buy.  There are several ETFs that cover most U.S. stocks such as the Dow Jones U.S. Total Market (IYY) or the Russell 3000 (IWV) or even MSCI EAFE Fund (EFA) that owns stocks from around the world.

However, ETFs are currently only available for index investing and not for actively managed funds.

Generally, ETFs are best when putting a large amount of money into an index fund all at once.  The trading costs will be saved by the lower annual expenses of these funds. 

What are ETFs?

ETFs are shares of a basket of stocks.  Investment companies create these stocks by buying the underlying stocks and issuing ETF shares.  Very large investors can issue new shares or redeem their shares for the underlying stocks.  This keeps the ETF price close in price to the underlying shares.  ETFs do not trade at sizable discounts or surpluses to the underlying stocks like closed end mutual funds.  If the ETFs begins to trade with any significant discount or surplus, large investors will issue new shares or redeem their shares to eliminate the discount or surplus.

You purchase ETFs just like any stock through your broker.  You can purchase them with market, limit, and stop orders, and you will pay a commission to buy or sell.

You can even sell ETFs short unlike mutual funds.  This allows you to use them for hedging strategies.  You can bet that a market sector or the entire market will drop in price for the commission price to short an individual stock.  However, an individual stock will be harder to predict since other factors such as a hostile takeover may raise the stock  price.  These factors will not have as great an impact on the broader ETF prices.  Many ETFs also have corresponding options.

How do ETFs compare to other investment types?

Other methods to achieve the same diversification are to individually buy a basket of stocks or purchase a mutual fund.  Let’s compare the three methods with an example.  Assume that you would like to own the 500 stocks in the S&P 500 index.  You could buy each of the 500 stocks from your stockbroker.  However, the trading commissions will add up to at least 500 times $10, which equals $5,000.  This is much more expensive than most people can afford.  Therefore, your two remaining options are to purchase a mutual fund or ETF.  For comparison purposes, I will assume that the stocks are purchased with a discount broker at the very low rate of $10 per trade.  The following table outlines the differences:

 

What are the different ETF types?

There are over 300 ETFs available.  They track all types of broad stock indexes as well as narrow sector indexes that concentrate on particular industries.  Many of the funds also invest internationally in addition to U.S. stocks and bonds.  They trade under various trade names that have small differences in their set-up.  The SPY, MDY, and QQQ fully replicate their indexes and cannot reinvest their dividends.  The iShares and SPDRs can optimize their index (therefore they might not own all the stocks within the index) and can reinvest dividends. 

Lastly, HOLDRS focus on narrow sectors by purchasing about 20 stocks.  This is narrower than the other ETF types, and HOLDRS can only be bought in 100 share multiples.  Dividends are distributed to investors, and the investors have voting rights for the companies owned by the HOLDRS.    

How do you select an ETF?

To select an ETF, first you must find which funds meet your investment objectives.  If you want to invest in large capitalization companies you can select funds indexed to the S&P500 or the Russell1000.  Small capitalization stocks are covered by the S&P Small Cap 600 or the Russell2000.  For sector investing, you have many choices.  Once you have selected your fund candidates examine the annual expenses, bid-offer spread, past performance, and top weighted members.

We have detailed ETF information by category.  We provide an outlook for each category, compare the funds, provide detailed information, and a category rating to guide our readers in buying and selling  specific Exchange Traded Funds (ETFs).  Click on the link to subscribe to our members only area to track our model portfolios, enter our contest, and exchange views with other subscribers in our ETF Forum.

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