Exchange-traded Funds Investing in Fast Track
New FED Flow of Funds Report Indicates ETFs Spending Big on Equities
Sep 25, 2009
Exchange-traded funds (ETFs) are index funds, which are usually passively managed. In some cases, managers depend on computer models to make decisions. The portfolios are theme-oriented, and in their composition simply mimic a securities index or some other asset model, like a business sector, geographic region or emerging industry.
As in all indexed funds, the exchange-traded fund investor owns shares of the mixture, with each share representing a proportionate amount of the whole. When compared to individual common stocks, this diversity provides a stability, although it often lacks the upside potential.
According to toni turner.com, more than 700 ETF funds trade in the US. They are valued at $700 billion. Investors can procure a fund prospectus from brokers or fund sponsors, which are usually large financial institutions like The Vanguard Group or Fidelity Investments.
Spiders, Qubes and Vipers Don't Scare Away Investors
ETFs are relatively new to the stock market arena. They were launched in 1993, when State Street Global Advisers joined the Amex Stock Exchange to create SPDRs or “Spiders.” These are shares in an ETF that mirror stocks contained in the Standard & Poor’s 500 Index. The James Bond trading symbol, “SPY,” has added a touch of excitement to the S&P 500, an otherwise staid market performer.
Besides “Spiders,” there are “Diamonds,” “Qubes” and “Vipers.” This montage of monikers shows that while Wall Street players might be greedy, they are certainly poetic. Investors can relax that "Spiders" are not Black Widows, "Diamonds" are not fake, "Qubes" are not aliens from outer space, and "Vipers" are not venomous.
Quebes Are Number One in Trading Volume Among Exchange-traded Funds
“Qubes” are the most popular EFT shares trading. With the trading symbol “QQQ,” they represent the stock composition of the 100-stock NASDAQ index.
"Diamonds" track stocks of the Dow-Jones Industrial Index, and trade as “DIA.” While they can shine in bull markets, they are not always a girl’s best friend, for bear markets can spoil a torrid romance.
Because they don’t experience negative cash flows from shareholders selling back shares at will, as do open-ended mutual funds, and because of rising incoming funds through newly-created ETFs , the group has expanded portfolio values dramatically. Those values rose by 23.1%, expressed as an annually-compounded rate, from the close of 2003 through the second quarter of 2009.
Closed-end Funds and Foreign Investors Round Out Top Three
The runner-up in the FED Flow of Funds sweepstakes is closed-end funds, which have grown their common stock holdings at a 6.7% compounded rate. Closed-end funds are like ETFs, in that the number of shares outstanding remains the same; but, among other important differences, closed-end funds are actively managed.
For more information about differences in closed-end funds and exchange-traded ones, see the excellent articles by James Brumley and Kathleen Winkler on Suite101.
Judging from the superior results of EFTs and closed-end funds in the FED flow of funds report, it seems the secret to surviving a bear market is to operate funds that can avoid massive redemption of shares.
Foreign investors moving into US markets occupied third place, with corporate equity growth of 3.3%. This increase suggests foreigners are looking with favor on US stimulus programs.
The list below shows the compound results of all the investment sectors.*
Investment Sector Equity Growth (2003-2009 2Q):
- Exchange-traded funds 23.1%
- Closed-end funds 6.7%
- Rest of the world 3.3%
- Federal government retirement funds 2.5%
- State and local governments 2.3%
- Mutual funds 1.4%
- Property-casualty insurance companies 1.2%
- Life insurance companies 1.2%
- All sectors corporate equities asset 0.5%
- Households and nonprofit organizations -1.2%
- State/local government retirement funds -2.0%
- Security brokers and dealers -2.4%
- Savings institutions -3.8%
- Private pension funds -3.8%
- Commercial banking -11.1%
(*) Excludes purchases of mutual fund shares.
In Characteristics an ETF Share Is Between a Mutual Fund and Common Stock
Exchange-traded Funds are like opened-end mutual funds, with the following important exceptions.
- EFT shares are closed-end, meaning fixed in shares outstanding, and trade like ordinary common stocks.
- Instead of a posted Net Asset Value (NAV) of its portfolio each day, as in the case of regular opened-end mutual funds, the stock market determines EFT share prices, which fluctuate daily.
- Investors pay brokers the same commission rate on ETFs as on other trading securities.
- ETFs can be purchased on margin and sold short.
- Options are available for trading ETFs.
Expense Ratios Are Lower for ETFs Than Mutual Funds
Perhaps the most important difference in an exchange-traded fund and opened-end mutual fund is in the expense ratios, or the annual expenses of running a fund, paid by shareholders. The ratio is expressed as a percentage of the total asset value of the fund. Managers sell shares of stock to pay these costs, which include salaries, travel, administration, advertising, etc. Of course, this lowers the value of shares.
The average opened-end fund expense ratio is 1.5 percent. Compare this with the ETF ratios in the exhibit in the panel of images below. Their calculated average is 0.43 percent. The source is Exchange Traded Funds (ETF) online.
Investors who want broad focus with diversification should consider Exchange-traded funds. However, they should check out other differences between ETFs and closed-end funds, besides the management styles mentioned above. When focused funds are right on about where to concentrate investments, they provide decent diversification and can outshine other funds.
Presently, they are attracting cash and deserve a close look by investors.
** The writer is a Chartered Financial Analyst (CFA).
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