The Michael Paul Wein Charitable Foundation

"Underpromise and Overdeliver"

ETFs

Understanding Exchange Traded Funds (ETFs) (copied, extracted, and edited, from Investor’s Journal – July/Aug 2005)

Exchange Traded Funds are hybrid investment vehicles combining the diversification of a mutual fund with the liquidity normally reserved for equities, but it is neither of these. If you seek portfolio diversification, intraday liquidity, and favorable tax treatment, take a closer look at ETFs.  

If it isn’t a stock, and it isn’t a mutual fund, just what exactly IS an Exchange Traded Fund?

An exchange-traded fund is very much like an index fund. ETFs have been around since the introduction of the Standard and Poor's Deposit Receipt (SPDR) in 1993. The SPDR provides a way to invest in the performance of the S&P 500 without having to purchase an index mutual fund, and without having to invest individually in each of the 500 companies comprising the index.

ETFs are created by large investors and institutions in blocks known as "Creation Units". Each creation requires that the creators deposit sufficient shares of stock in the industries or segments making up the ETF index to approximate the index’s composition, and cash in an amount equal to the accumulated dividends. Like mutual funds, ETFs are great diversification vehicles because they allow the investor to buy just one security while participating in the performance of all the underlying securities. ETFs are also outstanding vehicles for investing in sectors as well as specific geo-targeted areas.  

In addition to the SPDR, there are hundreds of other ETFs covering every major index from Dow Jones to NASDAQ, and all of the major equity market sectors like large caps, small caps, growth, and value. Geotargeted ETFs are available for country-specific and regional markets, and there are even industry-specific ETFs for biotech, REITs, transportation, energy, precious metals, and all of the others.  

ETFs are traded through brokers just like equities. Because they are not mutual funds, ETFs are not subject to loads, or traditional mutual fund management fees, or redemption fees. You do pay your usual brokerage commission however.  But, if you use a discount broker, you save mucho dinero on brokerage commissions..

One of the biggest advantages of ETF ownership over index mutual fund ownership is that the ETF can be traded intraday, while mutual funds may only be traded at the end of the day. This enables ETF investors to react to market changes in a timely manner and even day trade ETFs as if they were equities.  The other advantage is that ETF managers are never forced to liquidate underlying securities to satisfy the cash requirements that result when too many owners sell their shares at the same time. As a result, ETF owners are not as exposed to the possibility of surprise capital gains tax liabilities like mutual fund owners are. Nothing’s worse than watching the value of your mutual fund fall and still getting whacked with a capital gains tax; but it does happen. The MPWCF's founder, though, discourages you, the successor trustees, from day-trading as that is a low percentage idea and should NEVER be done.  Do not sell on bad news.   Do not buy on good news.  Think long-term and buy when the market is depressed and seldom sell.

There are some occasions when unexpected capital gains liabilities may be generated, but they are not as common as they are in mutual funds.  This, of course, is not important to a non-profit Foundation such as the MPWCF.  

Other positive features are that ETFs can be sold short, with some very specific products being exempt from the “up tick” rule for short sellers.  But, do not sell any securities short.  This Foundation is not a gambling unit.   Your fiduciary responsibilities require you to follow the investing principles stated by the Founder elsewhere on these web-pages, primarily on the trustees web-page.

Also, ETFs can be traded with stop loss orders, limits, and can be traded from within margin accounts.  

Every silver lining has a cloud, however, and there are some downsides to ETF ownership including: ETFs generate brokerage commissions, so they may be too expensive to trade within 401k and other retirement accounts. The fees can also have an adverse affect when dollar cost averaging.  This, of course, is not important to the MPWCFoundation as I would not expect Trustees to trade often, nor buy/sell in small lots.   Our current discount broker has a commission schedule that minimizes our commissions.

There are instances where the ETF trades at a premium over the value of the securities that it tracks. Like equities, ETFs are subject to slippage between the bid/ask price/  

Who should invest in ETFs?   The MPWCF should.

Because of the commission requirements, it can get expensive to build an ETF portfolio from the ground up. Discount and Internet-only brokers are a wise choice. More than likely the reduced management fees, as well as the lack of mutual fund-like expenses, will offset the one-time commission expenses of an ETF purchase or sale over the long term.  

ETF commission expenses don’t work well for people who make frequent withdrawals from their investment accounts. If that sounds like you, then you’re better of sticking with mutual funds. If you’re a hands-on investor who follows industry trends and likes to move on opportunities, ETFs are an easy way to strike while the iron is hot. Again, your discount brokers will be a better deal for you.  Remember, ETFs are like any other investment. They involve risk and you should never invest more than you are willing to lose. And even though they are traded intraday, there’s no guarantee of liquidity for the shares that you hold.

There’s always that chance that your ETF will be managed by someone who is not as competent as you would like them to be, or that world events will affect your holding. 

The Founder recommends diversifying among different types of ETFs similar to the following (each of which are basically diversified investments in their own classes). I would suggest (taking the below AND other securities in your entire portfolio) investing in value stocks more than growth stocks, and in sufficient stocks that promote your yield (dividends and perhaps some interest) rather than growth stocks, and in a mixture of mostly large cap with some small cap and mid cap stocks.