Exchange traded funds (ETFs) are versatile, easy to use and investor-friendly. They provide access to asset classes, sectors, commodities, currencies, fixed income and even hedge fund strategies.
What’s an ETF?
An ETF is a flexible, useful trading and investment vehicle that consists of a basket of stocks that track an underlying index. They trade all day on an exchange, just like a stock, but they hold baskets of stocks (usually), just like a mutual fund. They’ve been around since 1993. The first ETF, the SPDRS (NYSEArca: SPY), tracks the S&P 500. The strategy of indexing is not new, however. Barclay’s created it in 1971. [Our ETF Education Page.]
What are the advantages of ETFs?
Some of the advantages of ETFs include:
- You always know what you’re buying, because they replicate indexes. The holdings of those indexes are easily available and posted daily.
- ETFs offer safety in numbers. They have more diversification because they’re a basket of stocks rather than one individual stock.
- Their performance can be easily tracked.
- ETFs tend to have lower expenses and fees because they passively track indexes. There are no additional fees to pay to a fund manager. The average fee for a mutual fund is about 1.6%, while for a large-cap growth ETF it’s about 0.15%.
- They’re tax efficient because investors rarely generate capital gains.
What kind of investing strategy can be used with ETFs?
A simple strategy we suggest is to look for funds that are above their 200-day moving average. There are always areas that are trending up as others are going down. To learn more about this strategy and how to employ it, read our special report on trend following. [Coping Strategies for Bubbles.]
What about commodity ETFs?
There are four different types of commodity ETFs that investors who want to dabble in this area need to know:
- Equities. Equity-based commodity ETFs are funds that hold mining companies and other companies involved in the production of various commodities. Be aware that the performance of these companies are not always correlated to their underlying commodity. In the case of coal, steel and other commodities, sometimes equity-based commodity ETFs are the only way to gain exposure to these assets in an ETF. Long-term capital gains rate on equity-based ETFs is 15%, but be sure to consult your tax professional for further guidance. [More on Commodities.]
- Physical. Physical ETFs hold the actual physical commodity. Precious metals ETF holders would own an interest in a fractional amount of the physical commodity. The small investor may consider physical ETFs over holding the physical commodity because of costs associated with storage of the commodity. Potential investors should also note that profits in bullion-based ETFs are taxed at 28%, but consult your tax professional for advice. [All About the Platinum ETF.]
- Futures-based. Most commodities are traded on futures exchanges. A future is a promise to buy, or sell, a commodity for a set price at a set date in the near future. A majority of the future contracts traded on the exchange floor are settled or swapped for cash before the expiration date. Futures also add a time component to the price: when tomorrow’s cost is higher than today’s, it’s called contango; the inverse called backwardation. Investors should note that some ETFs have blind front-month roll strategies, but most ETFs now buy futures months in advance. None of these ETFs claim to deliver the spot price of the underlying commodity.
- Swaps-based. Swaps recently entered the ETF conversation when the popular United States Natural Gas (NYSEArca: UNG) turned to them in order to gain exposure. Generally, ETFs that invest in swaps receive the benchmark performance through the swap. The use of swaps give investors exposure to areas of the market that can be difficult to target. Read more about the benefits of swaps here. When the Commodity Futures Trading Commission (CFTC) announces regulatory changes, swaps could become a part of even more futures-based ETFs.
What do ETFs cost?
ETFs cost less, on average, than mutual funds. That doesn’t mean you should assume they all cost less. It’s important to do a little digging to make sure you’re getting the best price. Be aware that niche and specialty funds tend to cost a little more.
There are many uses and places within a portfolio to use an ETF, as well as specialized and specific roles they are now playing in markets. Use them with a firm strategy in place and with some knowledge and research they can do wonders. [Other Uses for ETFs.]
For more stories about ETFs, visit our ETF 101 category.