ETFs: The Supercharged Mutual Fund
While many investors have an overall outlook, and may be able to accurately predict what will be the next big thing, it is often harder to nail which company will be able to best take advantage of the coming conditions. After all, while it may be easy to figure out, retail stocks are going to be hammered by this recession, that doesn’t help you decide which retail company is best to short. And while it may be easy to figure out, reduced demand from the developed world is going to hurt Chinese companies, its much harder ” especially for those non-mandarin speaking people such as myself ” to figure out exactly which Chinese companies might escape this fate. So how can we take advantage of these outlooks without having to pick specific companies?
Exchange Traded Funds are the answer. Exchange traded funds (ETFs) allow you to invest in a group of companies all at once, similar to a mutual fund. The difference is that ETFs are traded directly on a stock exchange just like a stock, they can be bought and sold any time during the day without penalty, and they are both shortable, and optionable allowing you to take advantage of both up, and down moves in the market.
Each ETF is designed to mimic an investment in a certain industry, region, or type of stock. Some examples of ETFs are the XLI, XLU, and EWC. These ETFs grant an investor exposure to the industrial sector of the S&P 500, the utilities sector of the S&P 500, and the entire Canadian stock market, respectively. Similarly, one who simply wanted to match the S&P 500 indexs returns could just invest in the SPY.
But why shun the mutual fund? Why take the new guy over the established king? Lets start with the tax advantage. When mutual funds endure large sell offs, they have to liquidate many positions, some of which are currently at a gain. They then have to pay capital gains on those positions, and this negatively impacts their return. It would be an understatement to say that Mutual funds generally have higher expense ratios in general compared to ETFs. It can sometimes cost as little as 8 dollars to get into an ETF whereas a mutual fund of 20,000 that grows to 60,000 over a 20 year period may have conservatively lost as much as 18,000 to its competent managers.
Perhaps the biggest consideration is the simple convenience of owning ETFs when compared to mutual funds. They can be bought and sold (or shorted) any time during the trading day, using the same order types available to normal stocks. Free from redemption fees, the only deterrent from actively trading an ETF is belief in the efficient market hypothesis, and the standard commission costs from buying and selling stocks
Another important consideration is that most of the more liquid ETFs are optionable. This means that option-savvy investors can harness the power of stock options to change the risk-reward profile of their positions, and risk-conscious investors can use stratagems such as the covered call and protective put to protect their investment.
When investing in ETFs, its important to consider how exactly that ETF works. This can usually be found with a quick google search. While most ETFs attain their returns simply by holding the underlying securities, other ETFs use more exotic means to match their benchmark/investment objective, sometimes with varying success. Particularly important is the differentiation between an ETF and an ETN. ETNs are debt based investments, similar to bonds in some ways, and so their value is also partially dependent on the issuer. For this reason, investments in ETNs should be approached with caution, especially in the current, credit-tight market.
ETFs are a diverse tool that allows one to remove risk from ones portfolio by investing in sectors instead of individual companies. They allow investors to benefit from downturns in markets as well as the uptrends. And they allow the investor to take advantage of options on sectors, which options-savvy investors can use to supercharge returns. Given their great variety of uses, ETFs should be a valued part of any investors portfolio, to be ignored at the investors peril.
