Exchange traded funds are index funds which have advantages over open-end index mutual funds. ETFs trade all day long on the stock exchanges, may be purchased through any broker, have lower fund expenses than mutual funds, and have less likelihood of generating unwanted taxable gains than mutual funds.
There are a number of reasons, which we'll discuss, for investing in index funds (Exchange Traded Funds or mutual funds) but let's start with the fact that the S&P 500 index beats 80% of all actively managed funds. (And, an index fund has lower expenses than an actively managed fund, further enhancing its net return.) If you can invest in an index fund and be in the top 20 percentile of fund returns, that's a pretty good place to start.
You can construct a well-diversified portfolio entirely out of ETFs. There are Exchange Traded Funds for almost every type of investment you can imagine. Exchange Traded Funds enable you to diversify into assets which you may not otherwise feel comfortable owing because of expertise, risk and/or liquidity issues. They are well-suited for investing in exotic areas such as currencies and commodities. Of course, they're great for sectors such as small cap or international stocks.
One of the most attractive features of Exchange Traded Funds is their ability to provide you with greater liquidity than if you were to directly own their underlying investments. Take municipal bonds, for example. Most Muni issues trade infrequently and the transaction costs for the individual investor are substantial. Minimum investment size can be another problem. Munis typically have a $1,000 denomination and trade in large blocks. ETFs are the answer to all these issues. You can buy as little as one share of an ETF (generally less than $100) during market hours and at the same cost as for a stock.
You can hedge an investment and/or lock in gains using ETFs. Unlike open-end mutual funds, Exchange Traded Funds can be bought on margin and shorted. Investing on margin can magnify your returns and your losses. The ability to short enables you to make money when something goes down in value. Think shorting the dollar or home building stocks. However, to paraphrase TV commercials, these strategies should only be employed by a professional driver on a closed course.
It's also important to note that you don't have to short an ETF if you think an asset is going to decline in value. You can probably find an ETF which is structured to generate an inverse return to that asset. ProFunds Group has a number of ETFs designed to perform this way. So, for example, if you think the Chinese stock market will decline, you can purchase a ProFund which should increase in value if you're right.
All ETFs, even those which track the same index, are not the same. One S&P 500 ETF may weight its stock holdings by market cap, another may weight them all equally. This will result in different returns. Two ETFs which track the technology sector may hold different stocks and/or in different weightings. Since most indexes are not strictly defined, think technology versus S&P 500, there will be a variety of different investment strategies employed.
Different strategies to mimic an index are not good or bad, but they may have different risk levels and will produce different returns. Some ETFs also use leverage to enhance their returns or structure there holdings to magnify any gains (thus, also losses) of an index. You need to know what you're investing in. To understand how a specific ETF works, visit its website and read its prospectus.
Within five years most investors will have at least one ETF in their portfolio. Also, within five years, there will be more money invested in ETFs than in open end index mutual funds. The advantages of Exchange Traded Funds-liquidity, transparency and lower expenses, to name a few-will force changes in open end mutual funds. Happily, the investor will be the winner in the competition between these two investment vehicles.
Now the choices are becoming even more sophisticated. A new fund (Powershares DB G10 Currency Harvest Fund) has been created that aims to profit when the currencies of countries with higher interest rates outperform those with lower interest rates. This is known as the currency carry trade. This index is comprised of the group of 10 currencies which are: U.S. dollar; euro; Japanese Yen; Canadian dollar; Swiss franc; British pound; Australian dollar; New Zealand dollar; Norwegian krone, and Swiss krona.
The strategy here is that the index is designed to exploit the trend that currencies associated with relatively high interest rates tend to rise in value relative to currencies associated with low interest rates. This sophisticated index reflects long futures positions in three currencies with the highest interest rates, and short positions with the three currencies with the lowest interest rates. If one of three highest interest rate or three lowest interest rate currencies is the US dollar, the fund will not take a position.
Collateral for the currencies is provided by short-term treasury bills. This fixed income part of the portfolio provides yield which is used to offset the ETF fees.
Investors are looking for new asset classes to invest in. Currencies have a low correlation to stocks and bonds. The stock and bond markets have been recently been flat areas for investment money. The currency markets provide an asset class for investors to put their money. This is especially taking on significance now since the real estate market which has been attracting investment money, is now slowing down, especially in the residential sector.
This fund is much different from the single currency Exchange Traded funds such as the Euro Currency (FXE) fund that is managed by Rydex. This fund buys euros rather then currency futures. Rydex also manages currency funds tied to the British pound and the Mexican peso.
Unlike other currency related Exchange Traded Funds, the G10 Harvest fund is moving into the area of hedge funds with its sophisticated strategies. It is not just betting on the up down movements of a particular currency, but a rate spread strategy.
This leveraged long/short strategy has been used recently to take advantage of rock bottom interest rates in countries such as Japan and Switzerland. There is a risk, and that is that the US dollar will lose value against the Yen. Hedge funds and speculators have been making money on this trade. Now it appears they are starting to unwind their positions. There is some speculation that the carry trade has artificially propped up currencies that have higher interest rates.
For small investors, this fund gives them entrance to a strategy that only the larger players had access to. Even though this trade has been historically profitable, there is always a risk. Investors should understand the trade and the risks involved. This type of investment is not for everyone, however there are a number of small investors that may be attracted to it.
Traders should understand that this fund is highly speculative. It is intended as more of a long term investment and should not be used for frequent trading due to potential negative tax consequences. Traders could be lured into potentially damaging and costly trading. For US investors, this tool could be used for a long term diversification tool. With the political situation so volatile in the middle east and the economic consequences of interruption of energy supplies, investors must realize these markets can be very volatile which increases the risk.
Both Bill Byrnes & Andy Goldman are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
Bill Byrnes has sinced written about articles on various topics from Financial Planning, Currency Trading and Financial Planning. Bill Byrnes is co-founder of MUTUALdecision, , providing investors with data on the top mutual funds, and author of the MUTUALdecision Blog. He'. Bill Byrnes's top article generates over 6600 views. to your Favourites.
Andy Goldman has sinced written about articles on various topics from Stock, Currency Trading and Investing and Trading. Andrew Goldman is president of Metal Rabbit media services, the operator of He has written a number of articles on finance and environment over the last ten years.. Andy Goldman's top article generates over 6600 views. to your Favourites.