Q: What are ETFs and how do they work?
A: Exchange traded funds are pooled investment vehicles that offer a fractional interest in a broader basket of securities or commodities. While similar to traditional mutual funds, ETFs are constructed differently and possess certain advantages that make them an attractive alternative for many investors seeking allocation to broad indexes or targeted sector exposure.
By far the majority of these securities are passive funds that mimic an underlying stock, bond or commodity index and attempt to replicate the return of that index within a very narrow tracking error.
The first ETF, created in 1993, mirrored the S&P 500 index and came to be known as the "Spider" owing to its ticker symbol SPDR. Since that first offering, the universe of ETFs has expanded beyond 800 funds totaling nearly $800 billion.
Unlike conventional mutual funds which
offer investors the ability to redeem their shares once each day at the end of trading, ETFs trade continuously throughout the day on the major stock exchanges. They may also be sold short (borrowed from a brokerage firm and sold), may be purchased on margin, and typically sport lower expenses than comparable mutual funds.
ETFs offer a significant advantage for investors in taxable accounts. Traditional open-end mutual funds are required to sell underlying holdings each day to meet net redemptions, resulting in capital gains or losses that are reported at year-end to the remaining holders of the funds, often to their consternation.
Exchange traded fund shares are not redeemed but are traded like stocks, and therefore do not typically engender large unanticipated tax bills. The holder exercises control over the timing of tax incidence by deciding when to sell and hence when to report gains or losses.
In addition to index funds, ETFs have recently been introduced to facilitate exposure to specific sectors, as well as to commodities and bonds. According to the Investment Company Institute, commodity funds have proliferated to embody 10 percent of the ETF universe.
These hard-asset based funds are not regulated by the SEC but fall instead under the aegis of the Commodities Futures Trading Commission, and often use futures and options contracts to synthesize a position equivalent to holding the physical commodity.
For investors seeking to keep management costs down and gain exposure to broad indices or specific sectors, exchange traded funds are a convenient and attractive alternative.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Chris Hopkins is vice president, investments, at Barnett & Co. Inc. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com.