The Pros and Cons of Exchange-Traded Funds

Exchange-traded funds, just like mutual funds and interval funds, are investment companies whose main business activity is securities investment. Just like other investment companies, an exchange-traded fund's shares are held and owned by various investors who own a stake in the fund itself but do not own the instruments in which the fund is invested.

Exchange-Traded Funds: Distinguishing Features

Exchange-traded funds are classified as open-ended investment companies or unit investment trusts (UITs). However, they have unique features that distinguish them from other investment companies of the open-ended or UIT type. The following are the unique features of exchange-traded funds:

• Wholesale Share Sale

  Exchange-traded funds sell creation units rather than single shares. Such creation units are large blocks of individual shares. A creation unit may be composed of thousands of shares.

• Unique Purchasing Procedure

  Buyers of exchange-traded fund creation units usually pay, not with cash, but with other securities. To get a piece of an exchange-traded fund, an investor needs to put together a collection of securities to exchange for one or more creation units.

• Unique Redemption Procedures

  Just like other open-ended funds, an investor who owns or holds an exchange-traded fund's creation units can redeem these units by selling them back to the fund. However, instead of getting cash in exchange for his units, he will get a collection of securities instead.

• Institutional Buyers

  Creation units are usually too large for individual investors. Coming up with a collection of securities to exchange for a creation unit can also be difficult for individual investors. Thus, institutional investors make up the bulk of exchange-traded funds' investors.

  Individual investors can purchase shares of an exchange-traded fund from owners of the fund's creation units. In fact, institutional investors, after purchasing creation units, usually split up these large blocks and sell individual shares to interested investors.

Advantages of Exchange Traded Funds

Flexibility: Exchange-traded funds have the flexibility of stock. Like stock, they can be traded throughout the trading day. They can also be purchased on margin and bought on limit price orders. Investors can also buy just a few shares (in the secondary market) of an exchange-traded fund and short sell them.

Low Annual Expenses: Exchange-traded funds have a very low expense ratio. They are more cost-efficient than actively managed funds. Furthermore, they also have lower costs than index funds even if, like index funds, they usually replicate the composition of a particular market index.

For example, the average expense ratio of foreign equity funds is 1.92%, while the average expense ratio of index funds is 1.06%. The expense ratio of exchange-traded funds, on the other hand, ranges only from 0.35-0.99%.

The exchange-traded funds from SPDR, for example, have an average expense ratio of just 0.08%. The exchange-traded funds from iShares' also have low average expense ratio at 0.09% to 0.55%.

Tax Advantage: Exchange-traded funds are also said to be more tax friendly. When an investor sells his creation units to the fund, he gets the securities underlying these creation units instead of cash. This has the effect of minimizing capital gains and applicable capital gains taxes.

Diversification: Like some mutual funds and index funds, exchange-traded funds offers diversification by replicating the composition of a target index. Some exchange-traded funds even subdivide a particular market index according to the sectors within it like SPDR'S technology sector index, which contains stocks from the telecom, microcomputer, integrated computer circuits and defense manufacturer companies. Another example of an ETF diversified within a sector is Vanguard's VIPER which offers dozens of ETFs focusing on the utilities, financial and healthcare sectors.

Disadvantages of Exchange Traded Funds

Commission Costs on Small Purchases: Since exchange-traded funds trade like stock, there is a commission charge for every ETF purchase. This means that investors who regularly invest small amounts of money every month or so will find a significant portion of their investment money eaten up by sales loads. Exchange-traded funds are therefore a good choice only if the investor is making a one-time, lump-sum purchase. A better alternative for small and periodic investors would be no-load mutual funds or no-transaction-fee funds.

Dividend Drag: Another disadvantage of exchange-traded funds which may have a slight effect on their market performance is their inability to reinvest dividends. Exchange-traded funds are required to pay their shareholders dividends on a quarterly basis.

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