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ETFs Explained


ETFs, including funds devoted to domestic and foreign stocks, have grown to about $488.8 bln since the first fund started trading on the American Stock Exchange in 1993.

ETFs, or Exchange Traded Funds, represent a basket of stocks and offer diversification that few investors can match on their own.

ETFs aren't actively managed and this keeps costs low. Investors don't hold the shares directly. Instead, ETFs represent ownership shares in the fund that holds a portfolio of common stocks that track a market sector, index or international stocks.

"The basic mistake individual investors make with ETFs is that they don't use them in accordance with their own asset allocation policy – many just buy an ETF at random," says Philip Yockey, president and chief investment officer at Tactical Analytics, an independent research company. "The reality is that not all ETFs are designed to be a buy-and-hold – not every asset class works 365 days a year."

ETFs, including funds devoted to domestic and foreign stocks, have grown to about $488.8 bln since the first fund started trading on the American Stock Exchange in 1993. Mutual funds represent about $11.3 trln, the Investment Company Institute reports.

An ETF can be bought and sold as a single security. Just about anything that can be done with shares of common stock can be duplicated with an ETF. Unlike a mutual fund, ETFs can be traded intraday, shorted and placed with stop or limit orders. Many funds offer options.

Remember: Extensive trading will drive up your costs and erode your returns because most individual investors must go through a broker to buy into an ETF.

But that doesn't mean ETFs are on automatic pilot and investors can buy and forget about their money.

"In a bear market, it's silly for an investor to sit there and just grin and bear it and watch the investment go down the drain," Yockey says. "You've got to pay attention to ETFs just like anything else."

Tactical Analytics offers a Web site,, that tracks the performance of ETFs and provides investors with information needed to make sound decisions.

No one expects ETFs to slug it out with mutual funds for the affections – and assets – of individual investors. But if you're a long-term investor, ETFs offer distinct advantages, including low management fees and generally low exposure to capital gains. An ETF's diversification reduces risk without incurring upfront sales loads or redemption fees common to many mutual funds.

If you haven't read it yet, check out Scott Reeves' other primer, How to Read an Earnings Report.

ETFs enable investors to track just about any sector, including financial services, real estate, healthcare, technology, telecommunications, natural resources, utilities, semiconductors, software, biotech and manufacturing. Other funds track S&P indexes, the Russell 2000 and international equity indexes. The Nasdaq 100 Trust tracks the index and offers broad exposure to the technology sector.

The funds can be equally weighted or based on other parameters such as market-cap, liquidity and price/earnings ratio. Most funds are sliced every which way, but some invest heavily in a few major stocks such as Amgen (AMGN), Genentech (DNA) or CheckFree (CKFR).

An ETF investing in overseas stocks is likely to hold an array of stocks to limit volatility. But there are ETFs that track the new operations formed by the break-up of major foreign companies, including Brazil's telecommunications giant, Telebras, and Canada's Canadian Pacific Railway (CP). Another ETF tracks the stocks that comprise the Dow Jones Industrial Average.

In general, index funds have a lower turnover than actively managed funds. Typically, this means lower capital gains taxes.

However, ETFs may not be suitable for Mom and Pop because, in general, shares must be purchased in lots of 100. If an ETF's shares trade at $188.87, it would require an investment of $18,887, plus a broker's commission to participate.

Investors can't make monthly contributions to an ETF without getting slapped with a broker's fee. This makes ETFs a bad choice for monthly employee contributions to a retirement or education fund.

ETFs are dominated by institutional investors and hedge funds, but can make sense for individual investors.

If you're thinking about an ETF, be sure to check the fund's holdings to see that it provides the diversification you seek. Investors putting their money in an obscure ETF may encounter liquidity troubles, but a quick review of a fund's daily trading volume should eliminate this potential problem.

Some ETFs are eligible to receive dividends on the stocks held in trust, less fees. Read the prospectus to see if stocks held in the fund pay dividends.

ETFs can be purchased on margin. Contact your broker about margin requirements and fees.

ETFs don't deal directly with shareholders, cutting cost. However, you must buy and sell through a broker. If dealing in small amounts, this drives up the cost of trading and erodes returns. If you're a day trader and flip stocks quickly, ETFs probably aren't for you. But if you're a long-term investor, give ETFs a long look.

Like any other investment, do your homework. Start by reading the prospectus, a basic step some individual investors apparently skip in their haste to get in on what they see as the next big thing. Be mindful of cost and always keep an eye on your money.
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