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Using Exchange-Traded Funds (ETFs)


By Alex Vo, Contributing Blogger
From Vo Industries
Content Partner

Introduction

What are ETFs? They were first created in 1993 and similarly to mutual funds, they track multiple different companies with one unit. This gives you instant diversification with one trade. In other words, if one company suffers in a booming industry, and you happened to pick the company that was not doing so well, then you are out of luck. On the other hand if you bought an ETF in that booming industry, you will benefit from diversification.

A Bit of History

The first ETF tracked the S&P (SPY) but they did not become popular until the late 90s when the NASDAQ 100 ETF was created, known as the Q’s (QQQQ). However, purchasing an ETF is not the same as owning the stock outright. You will not receive voting rights. Usually, you should not even worry about that fact unless you own a large portion of the company.

ETFs and Mutual Funds

An ETF is not a mutual fund. You should already know my hatred towards those. ETFs are the best of both worlds. They can bring diversification like mutual funds but they can be traded as easily as stocks. As well, you will avoid those dumb, for lack of a better word, management fees and instead pay commissions for your trade. An ETF is a great first trade choice for a beginner investor.

Choosing which ETF to make your first trade with may be a little more difficult, but perhaps not by much. There are over 500 ETFs listed on the AMEX (American Stock Exchange–not American Express!), NYSE, and NASDAQ combined. Choose an industry that you have an expertise in and there is a very high chance that there will be an ETF covering just that. Peter Lynch’s (Wall Street investor and research consultant at Fidelity Investments) investing philosophy is “invest in what you know.”


What Can They Do?

If you want to track the S&P500, there are ETFs that track that. If you want to track a certain sector, such as the oil and gas sector, there are ETFs that do that as well. There are also ETFs that track the market in other countries, such as China. Finally, there are ETFs that track the fixed-income, such as the bond market. Get rid of that mutual fund and switch to ETFs!

Benefits to ETFs

  • Low cost.
  • Mutual funds that are supposed to be tracking a certain industry have underperformed the market during 70% of the last 20 years. If you cannot beat the market, then just buy the market. For example, if a mutual fund is supposed to be tracking the S&P500, 70% of the time, over the past 20 years, they have underperformed relative to the S&P!
  • Tax efficiency. ETFs generate fewer capital gains because of the low portfolio turnover. If someone withdraws in a mutual fund however, the investors still in that mutual fund are paying the capital gains tax for the person who withdrew!
  • When people buy and sell ETFs on an exchange, this results in a capital gain tax on only the investor trading that ETF. It will not affect others.
  • Invest in the entire market in one transaction. ETFs can be traded throughout the whole day when the market is open. They can also be purchased on the margin (borrowed money) and be shorted (sell your broker’s ETF, and buying it back at a lower price).

What Are Some ETFs?

Some of the common ETFs you will read or hear about are the Q’s (QQQQ) which tracks the top 100 stocks in the NASDAQ. You might have also heard about the Diamonds (DIA), which track the Dow Jones Industrial Average top 30 companies. Instead of going to purchase 30 different companies, you can make one trade and purchase the Diamonds. There are also the SPDRS (SPY) which tracks the S&P500 large caps and Russell 2000 Small and Mid Cap stocks (IWM). Other ETFs that track the broad market include the NYSE Composite Index Fund (NYC), the Dow Jones Wilshire Small Cap Index (DSC), and the Dow Jones Wilshire Total Market Index (TWM).

In addition to broad market ETFs, there are ETFs that track a sector, such as the S&P Retail Index (XRT) or the Dow Jones U.S. Energy Sector Index (IYE). Did you know there are also ETFs that track the pharmaceuticals (XPH), consumer staples (XLP), and technology (IYW)? How about the financial sector (IYF), which performed very well during our recent bull market? There are many more specific sector ETFs and if you are not able to find them online, send a comment my way and I will let you know if there is one!

As also mentioned earlier, there are ETFs that track countries, such as the Xinhua China 25 Index Fund (FXI) or the Brazil Index Fund (EWZ).

Finally, there are ETFs that track a trading style. The S&P 500 Value Index Fund (IVE) include companies that have low price to earnings ratios (P/E ratios) for value investors and the S&P 500 Growth Index Fund (IVW) which have high P/E ratios for growth investors. Bonds, commodities, currencies? Those are tracked by ETFs too! ETFs are everywhere and I highly recommend all investors, beginners, novices, and experts (although if you are an expert, you should already know this) to use ETFs in their portfolio. Gaining in a Down Trending Market Because ETFs are traded like stocks, they can be shorted as well. However, accounts such as IRAs (in the US), RSP (in Canada), and SIPP (in the UK) will not allow you to go short. There is another way around this. ProShares, one of the companies that issues ETFs, offer inverse and leveraged securities. Purchasing inverse ETFs will allow you to profit as the market goes down. These are identified by the word “short” in the ETF such as Short S&P500 (SH). Leveraged securities, such as the UltraShort S&P500 (SDS), will give you double the rate of return of the index it tracks. These are identified by the word “ultra” in the ETF. Questions, comments, or concerns? Send me a comment below! All questions will be answered, usually within 24 hours. Once again, I am looking for recommendations or suggestions on my blog posts. Is my writing style confusing? Does it all make sense? Should I slow down or provide more examples? Let me know what my readers want and I will cater to that!

By Alex Vo, Contributing Blogger
From Vo Industries
Content Partner

In association with:

The ARB Team
Arbitrage Magazine
Business News with BITE

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