How Are ETFs Different From Mutual Funds?

Posted by rpicon on Mar 11, 2011 in Market News | Comments Off

How Are ETFs Different From Mutual Funds?

Key Points

• Mutual Funds That Trade Like Stocks
• Comparing Costs
• Tax Consequences
• Fund Transparency
• A Balancing Act
• Points to Remember

You’ve probably heard of exchange-traded funds (ETFs), but you may not have a clear idea of how they work, how they differ from mutual funds, or how they might fit in your investment portfolio. Here’s your chance to take a closer look at ETFs and examine the characteristics they share with mutual funds as well as those that set them apart.

Mutual Funds That Trade Like Stocks

Although ETFs and mutual funds both register with the SEC as investment companies, they are structured and operate quite differently.

Mutual funds pool investors’ money to purchase a portfolio of securities. Each investor owns shares, which represent a portion of the holdings of the fund. Shareholders buy and sell shares based on the fund’s NAV — net asset value — which is calculated daily and fluctuates as fund holdings and shares outstanding change. Some mutual fund shares can be purchased from fund companies directly, while others are sold through brokers, banks, financial planners, or insurance agents. If you purchase mutual fund shares through a third party, there is a good chance you will pay a sales commission, or load. Increasingly, funds can be purchased through no-transaction-fee fund supermarkets that let you buy funds from many different companies.

When describing ETFs, it may help to think of them as mutual funds that trade like single stocks. ETF shares are created when an institutional investor or “authorized participant” deposits a specified block of securities with the fund. This “basket” of stocks reflects the composition of an index, such as the S&P 500 or the Nasdaq 100. Individual investors can buy and sell ETF shares only after they are listed on an exchange such the American Stock Exchange (AMEX) or the New York Stock Exchange (NYSE). Unlike mutual funds that must be purchased or sold at their end-of-day NAV, ETFs can be bought and sold in real time at prices that change throughout the day. Although ETFs still calculate an end-of-day NAV, intraday prices are based on investor demand. ETFs can thus be used for certain hedging strategies typically associated with stocks, such as buying on margin and selling short.

Comparing Costs

One of the key selling points of exchange-traded funds is cost. ETF expense ratios are generally lower than no-load index mutual funds and are significantly lower than actively managed mutual funds.¹ For instance, the average expense ratio is 0.56% for ETFs, 0.76% for index funds, and 1.17% for actively managed funds.²

These cost savings can be significant, especially for long-term investors. Although ETF investors will pay a brokerage commission on a per-trade basis to buy or sell shares, the savings from lower expenses can help offset these transaction costs.

Tax Consequences

One major tax advantage that sets ETFs apart from mutual funds is that ETF shareholders are not affected by the trading activity of fellow investors. For instance, mutual fund managers may be forced to sell portfolio holdings to meet the redemption demands of certain fund investors, resulting in an unexpected capital gain or loss to all shareholders. With ETFs, since trading takes place on an exchange between investors, the fund doesn’t need to sell stock to meet redemptions, thereby avoiding unforeseen tax events. In addition, the generally low portfolio turnover rate of ETFs contributes to their lower operating costs.

It should be noted that mutual funds and ETFs are required to make annual capital gains distributions to investors, which may be caused by index rebalancing. But as noted above, for ETF investors capital gains distributions are never caused by redemptions in the fund.

Fund Transparency

Today, investors are increasingly demanding more transparency with regard to fees, portfolio holdings, and other operational features. By design, ETFs and index mutual funds deliver greater transparency than actively managed mutual funds because their composition and performance are tied directly to the indexes they mimic. Individuals can easily gauge the performance of their investment by referring to the index it follows. By comparison, the holdings in actively managed funds are subject to change and are less easy to monitor.

A Balancing Act

Perhaps the biggest concern for investors with regard to ETFs is derived from one of their greatest attractions. ETFs are so easily bought and sold through a broker or by accessing an online trading account that investors could be tempted to trade too frequently and eliminate any tax or cost advantages due to transaction costs. Therefore, as with any other investment, ETFs should be considered carefully and used only as part of a tailored investment strategy.

Points to Remember

1.    Exchange-traded funds and mutual funds both register with the SEC as investment companies, but they are structured and operate quite differently.

2.    ETFs are often described as mutual funds that trade like single stocks.

3.    Unlike mutual funds that are purchased or sold only at the end of the trading day at their closing NAV, ETFs are bought and sold on an exchange throughout the day at “real-time” prices.

4.    ETFs can be used for certain hedging strategies typically associated with stocks, such as buying on margin and selling short.

5.    ETF expense ratios are generally lower than no-load index mutual funds and are significantly lower than actively managed mutual funds.

6.    Unlike mutual funds, ETF transactions do involve brokerage commissions.

¹An expense ratio represents the percentage of fund assets paid for operating expenses and management fees, including 12b-1 fees, administrative fees, and all other asset-based costs incurred by the fund except brokerage and trading costs.

²Source: Morningstar, December 2010. Expense ratios are calculated from the actual expenses paid if available; otherwise, they are calculated from the stated expense ratio in the fund’s prospectus.

###

© 2011 McGraw-Hill Financial Communications. All rights reserved.

March 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Dan Federman, CFP^®, a local member of FPA.

In Memory of Peter L. Gilsey, founder and Chairman of Ariba Asset Management

Posted by rpicon on Jul 7, 2010 in Market News | Comments Off

WHY IS THERE NO FEDERAL ENERGY PLAN TO UTILIZE THE VAST SUPPLY OF DOMESTIC NATURAL GAS?

Posted by rpicon on Jun 21, 2010 in Investor Education, Market News | Comments Off

NEWS YOU CAN USE FROM ARIBA RESEARCH – 6/21/10

118 BILLION BARRELS OF OIL EQUIVALENT IN THE LOWER 48 STATES READILY AVAILABLE IN SHALE GAS DEPOSITS

In April 2009, the U.S. Department of Energy estimated that the total amount of recoverable shale gas in the United States at 649.2 trillion cubic feet.  That is the energy equivalent of 118 billion barrels of oil – or about four times America’s proved oil reserves.  The development of horizontal drilling in 1997 has led to large scale gas drilling and production today and a huge increase in estimated reserves.  Some have estimated the domestic supply at 50 to 100 years.

The hydraulic fracturing (fracking) technology has now been successfully employed in shale oil with promising results and several major companies are in production.

MAJOR U.S.SHALE GAS BASINS

By way of comparison, the biggest conventional  oil discovery in the past decade is Tupi located off the coast of Brazil in7,000 feet of water and 17,000 feet under the ocean floor.  Tupi is believed to hold about 8 billion barrels of oil.  The Marcellus shale basin alone, in the Western Pennsylvania area, holds an estimated 45.6 billion barrels of oil equivalent in the form of natural gas – nearly 6 times as much as Tupi.  And the Marcellus basin is near major markets and existing infrastructure for delivery and storage.

SHALE OIL DEPOSITS

There are large shale oil deposits in the lower 48 states that are now in production through the use of newly developed fracking technology.

MANY ARE ASKING WHY THERE IS NO FEDERAL ENERGY PLAN TO UTILIZE THE VAST SUPPLY OF DOMESTIC NATURAL GAS AND WHY WE ARE DRILLING IN SUCH DIFFICULT AREAS AS THE DEEP WATER GULF. 

Trends in Shale Gas Production (MMcf / Day)

 Horizontal and Vertical Well Completions

Comments on European Debt Crisis

Posted by rpicon on Jun 16, 2010 in Market News | Comments Off

Comments on Recent Events (6-8-2010)

The European debt crisis is important because it is symptomatic of the global debt problem faced by most industrial nations. European banks may have to go through a period of restructuring debt and recapitalization similar to that of the U.S banks recap during the past two years.  U.S. banks are now well capitalized, but debt levels in the public and private sectors of industrial countries remain near record levels as a percentage of GDP as well as in absolute terms.

The way out of the debt problem is through private sector economic growth over an extended period of time while controlling government expenditures.  Such growth requires capital formation that comes from savings, rising productivity and growing credit availability.  With economies still deleveraging from overextended debt levels and banks unable to expand credit to accommodate needed growth, central banks in the U.S. and in Europe have begun to create new money (monetize debt). Such “quantitative easing” should encourage growth and buy time for deleveraging to work its way through global economies.

Investment implications:

Printing large quantities of new money may eventually lead to inflation after global economic recovery from recession, but maintaining liquidity in the banking system to avoiding deflation and fund economic growth is a much more pressing mandate at this time.

Newly created money will go into increased economic activity or financial assets (i.e. bonds, stocks, precious metals) and other so called “hard assets”.

Investor psychology may favor currencies of creditor nations, gold as an alternate currency and other “hard assets,” (i.e. real estate, energy, metals and mining).

The risk of mistakes (political or financial) remains high, as governments of debtor countries work through necessary deleveraging.  Even though there is reason to believe that the highly focused attention of both politicians and financial authorities will enable them to successfully maintain a functioning global financial system; it is clear that economic growth in Europe (and the U. S.) will be slow and unemployment will remain high.  The high level of fear among investors will make stock prices vulnerable to future shocks which are likely in a period of instability.  It is a time for caution.  TO SEE IF YOUR PORTFOLIO IS PROPERLY ALLOCATED, PLEASE CALL (703 683 8488 – ex 102) or e-mail (blong@aribaasset.com).