Why Exchange Traded Funds are Growing in Popularity

Posted by rpicon on Jul 28, 2010 in Investor Education | Comments Off

Why ETFs?

Retail mutual funds are outdated and expensive. Watch this video explanation to learn more about Exchange Traded Funds (ETFs) and why they are the “building blocks” of the portfolio of the future. Some of the benefits of ETFs include diversification, liquidity, tax efficiency, and transparency. They are growing rapidly as an investment vehicle. http://www.exploringetfs.com/?ut=fp

ETF Definition

An ETF is an investment vehicle that combines key features of  traditional mutual funds and individual stocks. ETFs are open-ended  funds which like index mutual funds represent portfolios of securities  that track specific indexes. A distinct difference is that ETFs trade  like stocks and can be bought and sold (long or short) on an exchange  and can employ the same trading strategies used with stocks.

Creation & Redemption

ETF shares are created differently than traditional shares of stocks.  Traditionally a company issues a set number of shares through an initial  public offering (IPO) and then the shares are traded in the secondary  market. Volume is an indication of how many shares are available at a  given price. ETF shares can essentially provide unlimited liquidity  through a process called creation and redemption. ETF shares can be  created on-demand by Authorized Participants such as institutional  trading desks and other approved market makers. They are released  directly into the secondary market. ETF volume is an indication of how  many shares have already traded, not how many shares could be traded.

Alternative to Mutual Funds

ETFs are an alternative to traditional mutual funds, with expense ratios that are typically 90% cheaper than actively managed mutual funds. They’re often cheaper than index mutual funds, too. While ETF transactions will most likely generate brokerage commissions, their lower expenses may offset those transaction costs for long-term investors.

Since most ETFs track indexes which are comprised of a basket of securities, they inherently provide instant diversification and are expected to reduce capital gains distributions through lower portfolio turnover than actively managed funds. Unlike traditional mutual funds where shareholder activity can contribute to capital gains distributions, an ETF’s creation and redemption structure eliminates the impact of shareholder activity on capital gains distributions thereby making them more tax efficient. Of course, if you sell a ETF at a gain, normal tax rules apply.