Having shifted the focus of this column to creepy-crawlies like those mentioned in the headline, you might be wondering if I've flipped through my calendar too quickly to Hallowe'en and forgotten the purpose of this column. But, no, I haven't yet broken the masks out of the closet; rest assured, you're in the right place for investment fundamentals and advice , and for the second in a series on understanding investment funds (see Aug. 21 issue for the basic primer). What do all these scary-sounding terms have in common? They're all acronyms for "exchange-traded funds" (ETFs), or index funds that are traded on stock exchanges. ETFs started in the mid-1990s with State Street's "spiders" , i.e. Standard & Poor's Depository Receipts (SPDRs). Major financial players such as Vanguard and Barclays Global Investors entered the game a little bit later; Vanguard created Vanguard Index Participation Receipts (VIPERs), while Barclays launched "diamonds" to track the popular Dow Jones Industrial Average, and followed with World Equity Benchmark Shares (WEBS) and iShares , both based on various MSCI indexes. Not to be outdone, State Street developed "tracks" to trace various specialized indexes.
ETFs are a hybrid of the open and closed-ended investment funds that I mentioned in the first of this series of articles. Like a closed-ended fund, they trade on the stock market, and thus you pay a brokerage commission when you buy or sell them. Like an open-ended fund, on the other hand, the number of shares available expands or contracts as demand rises or falls. They differ from most investment funds in that they track an index, as opposed to being actively managed. Thus they share a benefit of open-ended index funds that their expenses tend to be much lower than managed funds.
An ETF may also be defined as a hybrid of an index investment fund and a stock. Like stocks, ETFs trade on the stock market, and they allow you to select growth versus value or market capitalization, or to target a specific region or sector. Like an index investment fund, they have low fees and allow you to diversify without trying to pick individual stocks in a given region or sector.
You might be wondering why anyone would bother with ETFs when there are so many investment funds available to handle any of your needs. In addition to the lower fees due to indexing versus active management, there are actually many reasons. So allow me to share some of them with you.
All bases covered
With traditional investment funds or index funds, you first have to select the fund company or companies you want to work with, and then sign the appropriate paperwork before you start investing. Seldom, if ever, does any fund company have a full range of funds to meet all of your potential needs; certainly this is true of the companies operating in Hungary, and even U.S.-based behemoths like Fidelity and Vanguard don't have great expertise in certain niches , such as international equities or bonds.
With ETFs, however, a brokerage account that allows you to trade on a number of world exchanges opens up an entire galaxy of ETFs , and then some , to cover your needs.
ETFs are also advantageous when there's breaking news that could boost or hurt your investment value on a particular market. This is because you can buy or sell at any time during the trading day, and don't have to wait until the market closes to be on the receiving end of an unpredictable closing price of an investment fund. This, for example, could have been handy for investors on Oct. 19, 1987, or "Black Monday" , as I talked about way back when discussing my First Commandment of Investing: Buy Low, Sell High (see issue of Sept. 20, 2004).
Since the after-hours investment scandal broke a few years ago, most investment funds have imposed limits on the number of trades per year, and some impose fees if your investment is held for less than a selected number of months. This is especially true of specialized funds , such as the Japan Fund, whose shares I've traded for years. But I can assure you that no broker will limit the number of trades you make: The more you trade, the more they earn!
Because ETFs trade just like stocks, you don't have to buy them at the end-of-day price or current market price. You can place limit orders to buy if the price drops to a level you pick, or sell when the price rises to your target price. You can also protect yourself from sharp price drops by using stop-loss orders or stop-limit orders.
A stop-loss order merely means the sale order is executed if and when the price drops below the price you specify. The stop-limit adds a condition: Sell if the price drops below the stop price, but only if it is above the limit price. Thus you can protect your profits , and, for example, not sell when the price drops below the price at which you bought the ETF.
For more experienced and risk-tolerant investors, or those wanting to hedge their investment position, you can sell ETF shares short. A short sell involves selling shares you do not own by borrowing them from your broker with the intention of buying them back later at a lower price. It's the second profitable (reversed) variation of my First Commandment of Investing: namely, sell high, buy low.
A related benefit of ETFs is that you can take margin loans against shares that you own, and thus use leverage (or gearing) to enhance your returns. However, this carries the usual warning from me that there is no free lunch: If you're wrong and the market goes down, you'll lose even more.
You don't have to be concerned that ETFs have a shorter history and that there's less information available on their track records and comparative statistics. Morningstar, a news and analysis provider that prepares comparative statistics for investment funds, now also tracks and compares ETF performance.
The biggest buyers of ETFs are institutions and traders that make bets on the overall direction of the market. Investors fond of "passive" management also like ETFs , in other words, those who don't try to "beat" the market.
New horizons
So what's next for ETFs? Though it seems most of the creative ideas have already been launched, I still see activity on two fronts.
The first is that some ETFs are trying to actively beat the indexes. The legal structure of ETFs didn't foresee such active management, but if there's money to be made, someone will try.
Second, ETFs are locating more remote or obscure market indexes. For example, there's an ETF for the combined indexes in Poland, Hungary and the Czech Republic, and someone could even set up three separate ETFs for these markets. It should be noted, however, that liquidity becomes more of a problem with an ETF of this kind, and the spread between ask and bid prices widens, making it less efficient as an investment vehicle.
You might be wondering how ETFs differ from country or region-specific investment funds that have been around for years. Frankly, there are such funds for most major countries and regions, so ETFs thus represent an alternative means for investing in these areas, with the advantages I cited earlier. One example is BRICs (funds that focus on Brazil, Russia, India and China), which have proven very popular in the last few years. They are available through managed investment funds, as well as ETFs.
In the past, I've said that investment funds are the best way for individual investors to participate in financial markets. What you now know is that, in addition to the nearly 10,000 investment funds available worldwide, there are now some 330 ETFs , and their number is growing.
Once you know the investment fundamentals, and have decided on your asset allocation strategy, the rest is simple. So the logical next question is: What's the right asset allocation strategy for 2006 and 2007? Stay tuned to this column!
Investor Insights is a column providing tips on capital markets and personal wealth management. The author, a management consultant and portfolio manager, can be contacted on md@bi-solutions.biz.
