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ETFs Simplified (Part 2)

February 5, 2015
26 people like this post.

Traditionally, investors looking to hold a portfolio of index weighted stocks had two choices; invest in a mutual or managed fund, or attempt to partially replicate an index by buying some of the stocks within that index. Both of these methods have their disadvantages.

Using managed funds leaves your money at the hands of a fund manager, who may or may not have the same respect for your money as you do. Plus there are management and performance fees of various amounts that have to be paid to the fund manager.

Attempting to replicate an index by buying an amount of shares from within the index proportional to the cash you have available is costly in terms of both brokerage and time and for most investors is not a real consideration, hence the proliferation of managed funds.

The arrival of ETFs has, however, changed the investing landscape dramatically for a number of reasons. Since first becoming available to investors in 1989, it is estimated that there is over $2 trillion currently invested in ETFs and it is the fastest growing product segment in the money management industry. Some of the major benefits of using ETFs for both large, institutional investors, and ourselves as private investors include:

Ease of investing and flexibility

Traditional managed fund shares are traded only once per day after the markets close. All trading is done with the managed fund company that issues the units – managed fund units can’t be traded on the open market. Investors must wait until the end of the day when the fund net asset value (NAV) is announced before knowing what price they paid for new units when buying that day and the price they will receive for any units they sold that day.

The processes involved when buying and selling units in a managed fund are also quite laborious. In the great majority of cases this is done via completing a Prospectus to buy and a Redemption Form of some sort to exit. The process can take days.

ETFs by comparison are listed on the stock market. Just as it is for the share price of any company listed on the stock exchange, ETF share prices vary throughout the day, based mainly on the changing intraday value of the underlying assets in the fund. At any time of the day, you know exactly the price the ETF shares are trading at, and the price at which you can buy or sell.  As they are also subject to normal exchange settlement rules, you know when you will receive the funds from selling any shares, or when you will need funds available to settle the purchase of any ETF shares.

All from one account

Perhaps one of the biggest advantages for private traders and investors like us, is the fact that ETFs are listed on stock exchanges. This means that access to buying and selling ETFs can be done through our existing stock broker or online trading platform. There is no need to set up an account with a futures broker or FX broker if we want to gain access to the commodities or FX markets!

If we have an interest in trading crude oil for example, the traditional avenue for trading crude was in the futures markets via a futures broker. This requires the establishment of an account with the futures broker and time to learn the “ins and outs” of the futures markets – order types, margin requirements and so on. Now through the use of an ETF that tracks the price of crude oil, such as USO, we can effectively trade this market via our stock broker and our existing account!

Diversification

When buying units in a managed fund, you are essentially aiming to benefit from the “expertise” of a professional fund manager who buys and sells shares in companies in an attempt to either outperform a benchmark index or replicate the returns of that index, depending on the fund’s investment strategy.

ETFs by comparison, aim to replicate the performance of an index, sector, basket of securities, commodity, bond, emerging market, or any other combination as determined by the ETF creator. In this way, if, as a private investor, you desire exposure to the S&P500 Index, there is an ETF available. If you want exposure to the US electronic semi-conductor market, then there is an ETF for that!

ETFs allow you to gain exposure to markets, sectors, industries or specific countries that you would not otherwise be able to access using traditional investment products. You could, for example actively manage a basket of ETFs that provided exposure to a wide range of markets, taking advantage of the diversification offered by using ETFs. ETFs are now traded on virtually every major asset class, commodity, and currency in the world. Moreover, innovative new ETF structures embody a particular investment or trading strategy.

Reduce volatility

When you buy an ETF you are essentially buying a share in a bundle of securities that make up that ETF. When you buy the SPY (S&P500 Index ETF), you are buying a share in the ETF that already comprises all of the stocks that make up the S&P500 Index. If you buy shares in the semi-conductor ETF mentioned above, then you are buying shares in the ETF that comprises a basket of stocks from within that sector. This not only gives you diversification, but also helps to smooth out the volatility associated with attempting to pick individual stocks within the Index or any given sector or segment of the market.

Lower Costs

All managed funds charge fees to manage your money – management fees, expenses and performance fees, amongst others. ETFs have a much lower fee structure than traditional managed funds as many of the administrative costs of traditional funds are reduced or negated. ETFs don’t have marketing departments, custodial fees or client service related expenses.

The day to day reporting of prices and traded volumes occurs on the stock exchange and brokerage costs and other transaction fees are incurred directly with your stock broker. Your broker also reports directly to you, cutting out many of the administrative costs associated with managed funds. There are also zero redemption fees payable when you decide to sell an ETF as the only transaction cost is the fee charged by your stock broker.

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26 people like this post.

Comments

  • Robert Bertolini says:

    Thanks for yet another informative article. My only qualification is that you don’t mention the significant issue that Australian ETFs lack liquidity. They have market makers but at significant spreads and they are untested in times of crisis like GFC. Your comments in the US context are spot on but I don’t believe we have direct access to them e.g. USO.

  • Gary Stone says:

    Response to Comment by Robert:

    Your point about the illiquidity of ETFs on the ASX is a great one. Theoretically the liquidity of the underlying stocks that comprise the index that the ETF follows is a bigger issue than the liquidity of the ETF itself. And this is mostly true.

    However, wide spreads is the manifestation of low liquidity in the ETF itself. Not much can be done about this unless Limit orders are used to get the market maker to come to your price but the investor then runs the risk of not getting filled.

    ASX investors only have access to between 20 & 30 ETFs at the moment and whilst the number will grow I don’t believe that it will provide the spread of ETFs that Australian investors will need over time.

    This can only be achieved by investing in ETFs via a broker that provides access to the USA markets at reasonable brokerage rates. Such as Saxo Capital Markets, Interactive Brokers or a US based broker.

    Regards
    Gary

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