Published July 15, 2003

Are Exchange-Traded Funds Right For You?

Exchange-traded funds (ETFs) are index funds or trusts that are listed on an exchange, which can be traded intraday. ETFs hold portfolios of common stocks or bonds that are designed to track the price and yield performance of their underlying indexes. The index can be a broad stock market, an industry sector, an international stock market, or a U.S. bond index. An ETF investor can buy or sell shares in an index or trust as though buying or selling a share of stock. Nine years ago, the American Stock Exchange (AMEX) created Exchange Traded Funds with the introduction of the Standard & Poor's Depositary Receipt, which tracks the stocks included in the S&P 500 Index. ETFs now comprise a multi-billion-dollar industry; there are over 100 different products tracking U.S. and international stock markets, in addition to U.S. bond markets, currently traded at the AMEX. Exchange-traded funds offer many benefits, for both individual and institutional investors.

One of the primary features of exchange-traded funds is the diversification they can provide. ETFs represent a basket of stocks or bonds found in an entire index, and even those with small sums of money to invest can enjoy the benefits of diversification. ETFs offer exposure to a vast array of markets, including broad-based equity indexes, such as large-cap growth and small-cap value; broad-based and country-specific equity indexes, such as EAFE (Europe, Australasia, and the Far East), Europe, and Japan; industry-sector-specific indexes, such as energy and real estate; and U.S. bond indexes, including long-term Treasury bonds and corporate bonds. ETFs also offer potential dividend income, and interest paid on bonds held in an ETF is distributed to ETF holders on a monthly basis.

Another benefit of exchange-traded funds is how they are structured. Although ordinary brokerage commissions apply, ETFs generally have low cost structures. ETFs are index-based, and not actively managed. This limits the number of portfolio changes, owing to the fact that securities are bought and sold only to reflect changes in the underlying index, which significantly reduces transaction costs. Low turnover also results in lower capital gains than actively managed funds. Since they are passively managed, they generally have lower operating and management fees, which results in lower annual expense ratios than actively managed funds.

In addition, ETFs trade on an exchange and use "in kind" creation and redemption, which allow for the purchase or sale of shares of an ETF by payment in portfolio securities instead of cash. This shields them from the costs of selling securities in order to process shareholder purchases and redemptions. In addition to cost savings, this also enhances their tax efficiency, since investors who wish to purchase or sell shares simply trade with other investors. Although this can be a taxable event for the seller, this "in kind" transfer of securities is not a taxable event for the ETF. This is a sharp contrast to both actively managed funds and passively managed index mutual funds—these funds must meet shareholder redemptions through cash purchases or sales of the securities held by the fund, which can trigger capital gains. The creation and redemption process also allows arbitrage opportunities, which helps keep the traded price of the ETF in line with its underlying value. This process also infuses the market with a great deal of liquidity. Spreads on ETFs tend to be fairly narrow, as well. The spread is the difference between the bid price and the ask price. This may not hold true for ETFs that track certain foreign markets, however, especially in circumstances where trading volume may be low, which often causes spreads to widen.

ETFs also offer investors enormous flexibility. Unlike mutual funds, which are priced at the end of each trading day based on stocks' closing prices, exchange-traded funds can be purchased and sold intraday at the prevailing market price. For institutional or sophisticated individual investors, ETFs can be purchased on margin, and can be sold short, even on a downtick. They can also be traded using stop or limit orders. Sophisticated investors can also track ETF prices throughout the trading day and capitalize on sudden changes in the market.

Individual and institutional investors can utilize ETFs for a wide variety of trading strategies. Since they are easy to establish and track, inexpensive, and tax efficient, they are suitable as core portfolio investments. Their diversification provides a convenient way to adjust the investment mix, or fill in the gaps, of a portfolio. Investors can rebalance their portfolios throughout the trading day without redemption fees or short-term restrictions. Since they can be purchased on margin or sold short, they can be an effective hedging tool against market declines and interest-rate fluctuations. Institutions with idle cash can put it to work temporarily by purchasing an ETF, minimizing cash drag. Since futures contracts have an expiration date, institutions that purchase long-term futures contracts may incur lower trading costs by utilizing ETFs instead. If policy restrictions prohibit institutional investors from purchasing futures, ETFs may serve as a suitable alternative. An investor can also sell a security in order to generate a tax loss, but still maintain exposure to a sector or industry through the purchase of an exchange-traded fund.

Income-oriented investors may find fixed-income exchange-traded funds suitable for their investment needs. The growth of these investment vehicles allows investors indexing opportunities in bonds of different maturities and credit quality. Compared to individual bonds, fixed-income ETFs offer diversification and low minimum investments. When sized up against bond mutual funds, investors may find their intraday pricing and trading, monthly income, transparency of holdings (the composition of each ETF, both equity and fixed income, is published daily), and lower expense ratios more appealing than bond mutual funds. In comparison to equity ETFs, however, investors should be aware that, because of their higher yields, fixed-income ETFs might not be as tax efficient as equity ETFs. Also, because maturing bonds must be deleted from the portfolio, and newly issued bonds added, fixed-income ETFs may have higher turnover rates than equity ETFs.