Exchange Traded Funds – ETFs

| December 10, 2007 | 0 Comments

Diversification is important as we learned on Friday.  If you missed that article about a hedge fund manager who was not properly diversified you can read it here: “Learn from Hedge Fund Mistakes (and Save Millions).”

Most investors these days get diversification from mutual funds.  The major problem is that they don’t often know what is in the mutual fund. Even if they do know, the ability to buy and sell during the trading day is limited.  Holders of mutual funds are not able to use options to improve performance or protect from falling prices.  Fortunately, there is now a better way to diversify.

One of the newest investment categories is Exchange Traded Funds or ETFs.  These funds offer the diversification of a mutual fund without many of the problems.  In the last few years alone, ETF ownership has skyrocketed.  According to The Wall Street Journal more than $560 billion is invested in these funds.  ETFs provide an easy way to structure a portfolio and enhance returns.

I started using ETFs in my own personal portfolio several years ago and believe they are a valuable investment vehicle for both beginners and seasoned veterans.

In its most basic form an ETF is a fund that holds a fixed selection of stocks.  Some, like the iShares S&P 500 Fund (IVV), mirror an index. Others, like the SPDR S&P Homebuilders (XHB) ETF focus on a particular industry.  In this case the SPDR S&P Homebuilders ETF owns shares of homebuilders, construction suppliers, paint manufacturers, and even flooring companies.  ETFs also offer an easy way to invest internationally, without the headache of trying to trade on a foreign exchange.

So, why are ETFs so popular?

For starters they offer diversification, low fees, and active trading.  Then there’s the fact that you can trade optuons on them- a major plus.  When ETFs are first formed, the holdings are outlined for everyone to see and often the number of companies in the ETF can be quite broad.  For example, you can take $1,000 and invest in a S&P 500 ETF which gives you exposure to 500 different companies – instant diversification!

The holdings in an ETFs are rarely changed.  Because of this they have the lowest expense ratios of any fund, some as low as 0.09%.  Now you do need to buy and sell the ETFs through a broker (just like a stock) but if you use a discount broker those additional costs are minimal.

Another nice thing about ETFs is that they trade throughout the day.  If you want to sell your mutual fund you need to wait for the end of the trading day when they calculate the value and send you your money. ETFs on the other hand trade like stocks and as a result your broker can confirm a buy or sell order while you wait on the phone (or you can get instant execution online).

Some ETFs also offer the ability to use options.  As an example on the iShares Russell 2000 Index Fund (IWM) you can buy or sell puts and calls and even LEAPS. This gives advanced investors the opportunity to use options strategies to improve returns and manage risk.

One of the simplest options methods is to use ETFs for a “buy write” strategy.  You can also implement calendar and other spread trades using the ETF as the underlying security.

Additionally, ETFs make it very easy to short an industry.  Simply buy the put options and you have instant downside protection and can profit from a fall in the market.

On the whole ETFs offer a great number of advantages over traditional mutual funds.  Their diversification, low fee structure, and intraday trading make them an attractive tool to use in any portfolio.  Finally, the ability to utilize options strategies on these securities makes them an obvious choice for savvy investors.

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Category: ETFs

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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