Tuesday, July 7, 2009

What is the exchange-traded fund?

It seems that these days everybody wants to invest. The question that has to be asked is what instruments you are going to buy and why.

Because investing is a risky venture, I have often advised investors to go into mutual funds in the past. Another way is to go through the exchange-traded fund.

An exchange-traded fund is similar to a mutual fund except that it is traded in the stock exchange. Just as the mutual funds has many advantages over buying individual stocks, bonds and other investment instruments, the exchange-traded fund offer additional advantages that might interest the average investor.

You would remember that the mutual fund will buy a large portfolio of investment instruments. The net value of the mutual fund will be the market value of the all the stocks, bonds,etc of the portfolio of the fund. Thus the value of the mutual fund will increase if the value of the shares,bonds, etc increases and vice versa. However there is a problem with this. The market value of the a mutual fund portfolio is not an indication of good return. A mutual fund portfolio can be expensive but can have meager return while one that is quite cheap can have a good return.

This problem can be reduced by investing in exchange-traded fund.

What is the exchange-traded fund?

The exchange-traded fund is a mutual fund that trades on the stock exchange.Think of an exchange-traded fund as a mutual fund that trades like a stock. The company will buy a portfolio of shares and then will "go public". The company will issue stocks and these will be sold to the public. These shares of the exchange traded fund will then be traded on the stock market.

Hence the value of the exchange-traded fund will not be the total value of the portfolio like a mutual fund or the index fund. It will be the market capitalisation of all the value of the shares of the exchange-traded fund.

This is different in the fact that the value of the shares can fluctuate even if portfolio do not fluctuate. This will happen if the portfolio has a reduced learning potential. Hence the value of a mutual fund can remain constant in value while an exchange-traded fund composed of the same shares can fall in value.

So what are the advantages of investing in an exchange-traded fund?

1. Diversification

Since the exchange-traded fund invests in a wide range of stocks, then by buying the stock of an exchange-traded fund you already have the advantage of diversification. However the problem here is that if the exchange-traded fund goes down like in a sort of Madoff-like manager running away with the money, then you lose all your savings. Hence it is unwise to invest all your money in a single exchange-traded fund.

2. Advantages of a stock

Since the exchange-traded fund is traded in a stock market the everything that you can do with a stock you can do it with the exchange-traded fund. You will buy it like a stock using a stock broker and pay.fees and commissions, You can also call it, put it, etc. I would however discourage such exotic and risky style of investing.

3. Lower cost

The exchange-traded fund is usually cheaper to invest in compared to the mutual fund. That is because you need to pay only the broker commission when you buy it. Hence if you are using an online or discount broker

4. Diversity in a single stock

This might seem the same as the first one but it is a little bit different. Imagine that you have a portfolio of 15 stocks diversified in different sectors of the economy. In the traditional way of investing it is impossible to buy a lot of stocks in the same category. Imagine if you buy five stocks in each sector and you have 10 sectors of the economy then you have 50 different companies to monitor. This will be a huge task for the average investor. Also if you buy one or two in one sector and one of the companies go bankrupt then your exposure in that sector will disapppear.

The solution will be exchange-traded funds. Each exchange traded fund will specialised in one sector. For example you can have one in telecommunication that will be a basket of telco companies. If one of the companies in that sector go bankrupt then your stock will not be affected. Hence by investing in exchange-traded funds that are sector specialist instead of single stock in a sector you reduce your chance of losing your exposure to that sector.

5. Passive investment

Most exchange traded funds are passive investment

hence your return will be greater compared to a mutual fund that is actively managed. A normal mutual fund will have a lot of fees and commissions to pay as a result the profits will be less.

As you can see if you were thinking of investing then a mutual fund is good for you. Whether it is an exchange-traded fund, an index fund or a simple mutual fund the decision is yours. If you have any question leave a comment and me and my readers will try to give you an answer.

Introduction to diversification
What is an index fund?
What is a mutual fund?
The different types of mutual funds

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