To explain exchange-traded funds, one needs to understand the investment strategy of ETFs.
A little investment history is appropriate. Most people are not aware that in 1884, Charles Henry Dow averaged the closing prices of 11 stocks he considered representative of the strength of the U.S. economy in a paper that preceded The Wall Street Journal.
By 1896, The Wall Street Journal was publishing this average on a regular basis. This published average became the most famous indicator of stock market performance. The Dow Jones Industrial Average (DJIA or Dow) was born and become the most relevant stock indicator by investors.
Most people have heard of the Dow, as well as a few other well-known stock indexes such as the S&P 500 and Nasdaq. All of these indexes track the overall direction of the markets. Indexes and averages serve as useful benchmarks against which investors can measure the performance of their own portfolios.
Basically, indexes are imaginary portfolios of securities that represent a particular market or section of the market. Each index has its own method of calculating a change in its base value, often expressed as a percentage change.
Although you can’t invest directly in an index, you can invest in an index mutual fund, also known as an exchange-traded fund (ETF), that attempts to mirror a particular index by investing in the securities that comprise the index. The performance of an unmanaged index is not indicative of the performance of any specific investment.
ETFs have some qualities that set them apart from other investment vehicles. ETFs are securities that attempt to track all types of indexes, industries, or commodities. For example, an ETF might be made up of securities representative of the technological industry or of the S&P 500.
When ETFs were first created in the 1990s, the aim was to mimic the movements of an index of a specific financial benchmark. Today, ETFs also follow industries and commodities, not just indexes. An investment vehicle with the sole purpose of mirroring a specific index is called an index fund.
One of the reasons some investors may choose ETFs is because they combine the diversification of a mutual fund with the flexibility of a stock. ETFs do not have their net asset values calculated each day, as do typical mutual funds, but rather their prices may fluctuate throughout the day based on the rate of demand on the open market.
Although the value of an ETF comes from the worth of the underlying assets comprising it, shares may trade at a premium or a discount. ETF shares are sold on stock exchanges; investors can buy or sell them at any time during the day. The underlying assets of the fund are not affected by market trading.
Exchange-traded funds may have expense ratios that are lower than those of an average mutual fund, and they are usually more tax-efficient than most mutual funds. Additionally, shareholders can often invest as little or as much as they desire. However, an ETF cannot be redeemed by a shareholder; rather, it is only sold on the stock market.
A downside to ETFs is the commission fee. Commissions are involved because ETFs are traded like stocks, rather than like mutual funds. However, despite this downside, an ETF can be a diversified and low-cost investment that often has a low turnover rate.
Since you can basically create or develop an ETF for practically anything you want, the popularity of inverse ETF has exploded as an alternative way to short any market and profit in a bear market.
Since most investors don’t know how to short stocks (nor have the account to do it) you can now buy “short exposure” to ETFs that inversely track an underlying index or investment product.
The more popular inverse ETFs promise to make you the exact opposite return of an underlying index. Seems like great way to leverage a falling market right? After all, the fund’s prospectus clearly guarantees the inverse of the daily return of the index.
For those that do not have the time to trade ETF’s or do not want to get involved in setting up a trading account and have a broker trade for you, there is an option. Some specific mutual funds do trade ETFs this way, and it is done inside of the mutual fund.
Information in this column is not intended to be specific advice for anyone. Carefully review the prospectus of any product you invest in. You should use this information to help you work with a professional regarding your specific financial objectives.
Capt. Mark A. Cline is a chartered senior financial planner. Comments on this column are welcome at +1-954-764-2929 or through www.clinefinancial.net.