News





A guide to everything you ever wanted to know about ETFs but were afraid to ask


What Is An ETF?

An ETF (acronym for Exchange Traded Fund), is an investment tool composed of a “basket” of securities used to track an index, sector, or commodity. When explaining an ETF it is useful to discuss its similarities and differences with mutual funds. ETFs are similar to index mutual funds because they enable an investor to purchase a small slice of a much larger investment pie. ETFs are composed of many securities of which the investor purchases only a part. Therefore, when investors buy a share of an ETF, they are purchasing a piece of many different securities grouped together to serve a specific need, such as tracking the S&P 500 Index or the price of oil.

Although ETFs are similar to mutual funds, ETFs have several differences. Because ETFs are traded like shares of common stock and are therefore priced continually throughout a trading session they can be bought or sold whenever the market is open. Mutual funds on the other hand are priced only once after the end of a trading session, and therefore an investor can buy and sell them only at that time. Like common stock ETFs can also be sold short or bought on margin.

The differences between mutual funds and ETFs lie in the creation process of each product. A mutual fund invests an investor’s money directly in the open market and therefore investors participate proportionally in gains or losses in the fund. An ETF, on the other hand, is created through a complex process where the initial securities are lent by large institutions such as pension funds and pooled at an outside holding company, called a custodian. After the assets are pooled, they are sent to the creator of the ETF, the “authorized participant”, in the form of individual shares. This transfer is usually quite large and is made “in- kind”, which means the transfer is not registered as a purchase or sale. Because the delivered unit is an individual security, it now can be sold liquidly on the open market. [1] The average investor can benefit from investing in ETFs because this somewhat complex process provides several advantages, which are described below.       

Why Use ETFs? 

ETFs are a great way to diversify a portfolio and make sector or index wide allocations without incurring a great deal of brokerage fees. In order to achieve a truly diversified portfolio an investor must invest in a considerable number of securities, and depending on the broker this can add up to significant money spent in transaction charges. Because ETFs are composed of a "basket" of securities, by purchasing just one share of an ETF, an investor can achieve extensive market diversification. ETFs also can be used to make sector wide decisions without choosing any specific companies. For example, if an investor wanted to gain exposure to the Chinese stock market but lacked knowledge of specific Chinese stocks, he or she could purchase an ETF that tracks the Chinese Xinhau 25 Index. This would enable the investor to allocate to a market or sector rather than to an individual company. 

All of the advantages discussed above also can be attained through investing in index mutual funds. ETFs, however, have some advantages over mutual funds that can make them more attractive to the right investor. The fact that ETFs can be bought and sold liquidly gives the investor greater market timing and control. Likewise, ETFs do not have the entry or exit fee of some mutual funds and do not have any penalties associated with frequent trades in the same fund.

ETFs are also tax efficient. Because the creation process of an ETF involves an “in-kind” transfer, the ETF for equivalent certificates of the stocks that make up the "basket", capital gains are not realized until the investor buys or sells the actual ETF. Because capital gains can be avoided as long as possible, the investor can accumulate more money free of taxes. Mutual funds, because they operate directly in the open market, trigger fees from capital gains immediately upon sales within the fund, and those fees are passed on directly to the fund’s investors.[2] This tax advantage allows the average ETF to pay less annual expenses and therefore ETFs charge a lower average fee than most mutual funds. The average ETF investor pays $25 dollars per $10,000 of assets compared to $91 per $10,000 worth of assets for actively managed mutual funds.[3]

Who Provides ETFs?

ETFs are provided mainly by large banks with dedicated ETF departments. Currently, the largest provider is BlackRock Inc., which manages the iShares ETFs. State Street Global Advisors, which manages the single largest ETF tracking the S&P 500 Index (ticker symbol SPY), is the second largest provider, followed by The Vanguard Group. Recently more niche providers, most notably PowerShares, have come into the market that  provide more specialized ETFs, such as double long or double short ETFs.[3]

Although ETFs first came into existence in the 1990's, they have boomed in recent years. According to Bloomberg.com, “Assets in the U.S. exchange-traded funds totaled $731.7 billion as of January 31, 2010, up 48 percent from a year earlier.” This large and rapidly growing market is traded mainly on the New York Stock Exchange’s electronic platforms of Arca and EuroNext, and is subject to considerable SEC regulation.[4]

How Does Howe & Rusling Use ETFs?       

For smaller clients, Howe & Rusling uses a portfolio composed of a few carefully selected ETFs. ETFs are selected to follow specific sectors of interest and are judged on past performance, liquidity, and expense ratios. The purpose of our ETF portfolio is to allow our clients with smaller portfolios to achieve the diversification and sector allocations of our larger clients, without sustaining a disproportionate amount of transaction charges. 

The advantage of using Howe & Rusling to manage your ETFs is in our understanding of the product and the market. Our relationships with and knowledge of ETF providers enables Howe & Rusling to avoid unattractive ETF prices due to discrepancies between the market for an individual ETF and the market for its underlying securities. More importantly, because the Howe & Rusling Equity Group constantly monitors and changes the sector weightings of our ETF portfolio in accordance with their view of the market, our ETF clients adapt quickly to changing market conditions. Based on the benefits discussed in this overview and your individual needs, the Howe & Rusling ETF portfolio could be an ideal way to stay diversified and on top of the market. 

For more information on the Howe & Rusling ETF portfolio and how it may work for you please contact Tim Hamilton HERE >





[1] "How ETFs Work? - ETF Center - Yahoo! Finance." Yahoo! Finance - Business Finance, Stock Market, Quotes, News. Web. 31 Aug. 2010. <http://finance.yahoo.com/etf/education/01>.



[2] "How ETFs Work? - ETF Center - Yahoo! Finance." Yahoo! Finance - Business Finance, Stock Market, Quotes, News. Web. 31 Aug. 2010. <http://finance.yahoo.com/etf/education/01>.



[3] Bhaktavatsalam, Sree. "About ETFs - Bloomberg." Bloomberg - Business & Financial News, Breaking News Headlines. Web. 31 Aug. 2010. <http://www.bloomberg.com/markets/etfs/etf_about.html>.



[4] Lydon, Tom. "The NYSE: Where An ETF’s Life Begins « ETF Trends." ETF Trends. Web. 31 Aug. 2010. http://www.etftrends.com//2009/12/exchange-where-etfs-life-begins/.