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As you may already understand, a mutual fund is an arrangement in which investors pool their money and hire a portfolio manager to buy and sell securities on their behalf.
Unless the fund company is buying back shares, or selling founding shares to its initial subscribers, the fund company itself is not involved with secondary market transactions. One key difference: When you buy open-end funds, your counterparty (who you buy from) is always the fund company itself. With closed-end funds and exchange-traded funds, on the other hand, your counterparty isn’t normally the fund company itself, but other shareholders who buy or sell shares all day long, either directly or, more commonly, over stock exchanges. Because ETF shareholders don’t need to pay a manager and a team of analysts and brokers to buy and sell funds on their behalf, nor to manage fund inflows and outflows, exchange traded funds typically have much lower expense ratios than traditional mutual funds.
For example, many large cap mutual funds charge expense ratios of 80 basis points, or 0.8% per year, or more. When you buy an open-end mutual fund, you can only buy fund shares once per day, at their net asset value as of the last market close.
ETFs and closed-end mutual funds can both be sold throughout the day over the stock exchanges, though some funds are more frequently traded than others. With open-end funds, you can’t engage in short selling, the practice of borrowing shares and selling them in the expectation that share prices will fall. Index funds, including ETFs, tend to be very tax efficient and ideal for holding in taxable accounts.
Every time a fund sells a share at a profit, the IRS assesses capital gains tax – which gets passed on to shareholders.
ETFs are usually slightly more tax-efficient than open-end index funds, because ETFs don’t have to concern themselves with selling shares to meet redemptions. However, if the ETF’s portfolio generates dividend income, this income is taxable, just as it is with closed-end and open-end mutual funds.
When fund shares get traded in the open market as opposed to being redeemed directly from the fund company itself, it is investors that determine share prices.
Many investors like to have dividends automatically reinvested in fund shares, in a DRIP, or dividend reinvestment plan. I like exchange traded funds so very much because they can reduce your risk because when buying a exchange traded fund your buying a whole basket of stocks instead of just a single security. Exchange-traded funds (ETFs) are investment companies that create and sell shares in a fund that represents a beneficial interest in the holdings of the fund, which can include stocks, bonds, and other securities, and these ETF shares are traded on a stock exchange, and bought and sold through a broker-dealer, just like a stock.
An exchange-traded fund is a mutual fund and is regulated as such by the Securities and Exchange Commission (SEC). ETFs were first sold in Europe in 2000, 7 years after their introduction to the United States market, but because of less regulation, specifically, not requiring to register new ETF funds under the Investment Company Act of 1940, many new ETF products are first developed and test marketed in Europe before being sold in the much larger United States market.Examples of products first sold in Europe, and then the United States include ETFs based on leveraged funds, oil, and gold. They have a number of advantages over mutual funds, and you can buy ETFs that focus on nearly any market you can imagine.
Learn how they differ from mutual funds, and investigate their advantages and disadvantages relative to conventional mutual funds. With traditional open-end mutual funds, investors can buy or sell shares directly from the fund company itself.
However, just as with open-end mutual funds, you still have a fund manager (or a team of managers) trying to buy and sell securities on shareholders’ behalf. Like closed-end fund shares, ETF shares can be bought and sold over stock exchanges, just like any other stock.
Their expense ratios also tend to be lower than open-end index funds, because even open-end index funds have to keep enough staff on hand to process constant purchases and redemptions. When you buy or sell an ETF or closed-end fund, you will generally need to pay a commission to a broker – though some low-cost online brokerages have commission charges as low as $4 per trade. The more frequently the fund is traded, the easier it generally is to find a willing buyer or seller in a hurry. This is because portfolio turnover in index funds is very low, whereas managers of actively managed funds sell securities and buy new ones every time they have a better investment idea. Since index funds and ETFs don’t sell shares very often, it is very rare for them to generate a taxable distribution for their shareholders. Investors seeking to benefit from buying fund shares at a discount may be better off going with an actively managed closed-end fund rather than an ETF.

However, this is usually not done with ETFs, as it would require too much fund administration and drive up fund costs. This gives the lower long-term expense ratios of these securities (compared to competing actively managed mutual funds and even open-end index funds) time to build up.
For further details about how to go about investing in an ETF, and whether it makes sense for your situation, speak to a trusted financial advisor, or do your own due diligence on the fund or funds in which you’re interested. Products that are still being tested — as of September, 2006 — in Europe include active management funds, capital-protection funds, and commodities like aluminum and wheat.Exchange-Traded Funds ResourcesETF Dynamic HeatmapThis is a nice ETF Heatmap on the NASDAQ website that is updated every minute during market hours. Closed-end fund shares, however, are traded over exchanges just like a stock, and are typically purchased from other shareholders. Index funds and ETFs, on the other hand, only sell shares when new securities get dropped from the index, and buy shares only when they are added to the index. This helps shelter the fund’s remaining shareholders from the tax consequences of the sale.
With closed-end funds, it is frequently possible to buy fund shares at a 5% to 15% discount to net asset value. They are also very useful as trading vehicles, especially if you don’t want to drill-down too deeply in any one company, or retain too much individual company risk. But I’ve never seen a lot of value in the ability to sell ETF shares during the day as opposed to at the end of the day (as is the case with mutual funds).
The second advantage of exchange traded funds is that their are now thousands of funds to choose from.
In most cases, the fund also buys these securities in proportion to their weights in the index, although there are exceptions to this. But the shareholder gets the full benefit of any dividends or interest payments from the fund and the potential for capital appreciation if discounts narrow. If the index rises, so do share prices in long ETFs, by about the same amount, minus any expenses and trading costs.
And you won’t know if your fund manager is taking any action to preserve shareholder value in the meantime.
Exchange-traded funds evolved from closed-end funds and American Depositary Receipts.The main assets of the fund are its securities, and the net asset value (NAV) of the fund is the total market value of the fund’s securities, plus any other assets, such as cash, minus its liabilities, then dividing the result by the total number of ETF shares outstanding. To reduce taxes for the fund, the ETF sponsor returns securities with the lowest tax basis to the Authorized Participants, so that when the ETF sponsor does have to sell some securities in the future, the securities remaining with the ETF sponsor will have a higher tax basis that will generate smaller capital gains for the fund. In falling markets, however, a low cash position hurts the fund – the portfolio bears the full brunt of the market decline.
Note that the exchange of ETF shares and the securities they represent between the Authorized Participants and the ETF sponsor is an in-kind exchange—there is no exchange of cash. This also lowers taxes for the ETF sponsor, thereby lowering the fund’s fees.Retail investors have no relationship with the ETF sponsor. With companies becoming more global, custodian banks have expanded their services to include foreign-exchange trading and securities lending. When a security is added to the index, the Authorized Participants deliver the newly added security to the ETF sponsor, and the ETF sponsor returns any securities that were deleted from the index to the Authorized Participants.Because both the ETF shares and the securities composing the fund trade independently of each other, there is usually a price discrepancy between the ETF share price and the NAV. Authorized Participants can exchange either the shares of the ETF for its underlying securities, or vice versa, whichever yields a profit for the Authorized Participants. This exchange is in-kind, trading creation units of ETF shares for the securities.Thus, if the share price of the ETF is significantly lower than its NAV, then that means that the securities represented by the ETF shares can be sold for more money than needed to buy the ETF shares. So an Authorized Participant can buy ETF shares on the open market, exchange them for the underlying securities, then sell the securities for a profit. In fact, the very first ETF, first marketed in January, 1993, was called the Standard and Poor Depositary Receipts, which represented an interest in a fund that tracked the stocks that compose the S&P 500 stock index.
This buying and selling of related securities to profit from the price differences is called arbitrage.However, there will be some difference between the NAV of an ETF and its share price, because market demand will differ by at least a small amount at any time, and the price discrepancy must be great enough for a substantial arbitrage profit that will cover transaction costs and pay a risk premium, since there is some risk for Authorized Participants in exchanging ETF shares for its underlying securities. Market prices can change quickly, and they may change unfavorably in the time that the Authorized Participant takes in effecting the arbitrage.This provision for arbitrage is what differentiates ETFs fundamentally from closed-end mutual funds. A closed-end mutual fund is much like an ETF—it sells shares representing a basket of securities on a stock exchange, and trades just like a stock, but, because it has no legal provision for exchanging the shares of the fund for the securities after the fund is created, the share price of the fund frequently deviates by a large amount from the NAV of the fund.Another common difference between closed-end mutual funds and ETFs is that, often, closed-end funds use leverage in buying its portfolio. Interest paid on the borrowed money will also increase expenses.Legal Structures of Exchange-Traded FundsThere are 3 main legal structures for exchange-traded funds, which determines, to some extent, how they operate.

An ETF organized as an open-end mutual fund or a unit investment trust are required to register as investment companies under the Investment Company Act of 1940.ETFs Organized as an Open-End FundAn exchange-traded fund organized as an open-end investment company must supply investors in the secondary market with a Product Description, or profile, which summarizes key information contained in the fund’s prospectus, such as the fund's investment objectives, principal investment strategies, principal risks, performance, fees and expenses, identity of the fund’s investment adviser, investment requirements, and other information, and informs investors on how to obtain a prospectus. These reports contain a variety of updated financial information, a list of the fund’s portfolio securities, and other information.Open-end ETFs reinvest dividends as soon as they are received and are paid out quarterly. To increase income, the fund can include derivatives in its portfolio and lend its securities.ETFs Organized as Unit Investment TrustsAlthough ETFs organized as unit investment trusts (UIT) track an index, they are restricted as to security weightings. The best example of this kind of trust is the NASDAQ-100 Trust, which sponsors the QQQQ ETF and is currently the most actively traded ETF.Exchange-Traded Grantor TrustsThe exchange-traded grantor trust is not a registered investment company, and is not an actual ETF. One market manager said that when a new ETF comes out, he looks for securities in that ETF to sell.Actively Managed Exchange-Traded FundsThe main reason why ETFs are not actively managed is because the fund manager would have to reveal what he is buying or selling, thereby allowing traders to trade ahead of the ETF company for greater profits and at a greater cost to the company. Investors have voting rights in the companies composing the fund, and the investors can create or redeem shares in round lots of 100.
Holding Company Depositary Receipts (HOLDRs), a proprietary product of Merrill Lynch, is an example of the exchange-traded grantor trust. HOLDRs generally cover a narrow sector of the market, such as the Biotech (BBH) or Broadband (BDH) HOLDRs.The portfolio of the exchange-traded grantor trust does not change, and, thus, cannot be rebalanced, which can lead to less diversification as some of the companies grow larger than the others in the portfolio, nor can stocks that fit the trust’s profile be added later.
Holdrs Trust (HHH) has more than 50% of its portfolio invested in just Yahoo and eBay, but none in Google, because Google had it’s IPO after this HOLDR was created.Buying and Selling ETF Shares on an ExchangeMost ETF shares trade on the American Stock Exchange, which is now part of NYSE Euronext, with an increasing number trading on the NASDAQ exchange. Unlike the shares of an open-end mutual fund, fractional shares cannot be purchased, nor can dividends be reinvested easily and cheaply, and brokerage commissions make it more expensive to invest small amounts frequently. If the price of the ETF shares drops significantly below the NAV of the fund, then Authorized Participants will buy up the ETF shares to exchange them for the underlying securities. Selling ETF shares short is a popular hedging technique.Exchange-Traded Funds as an InvestmentExchange-traded funds provide good diversification for small investments. Thus, they moderate risks, but they also moderate returns.They have lower expenses than other mutual funds because most ETFs are based on an index, and thus, are not actively managed, thereby reducing management fees. There are new ETF funds being created continually, and some of these may require active management, which will create higher fees. Administration fees are also less because there is less interaction with individual investors than with an open-end mutual fund. When an investor in an open-end mutual fund wants to redeem his shares, he sells them back to the fund in exchange for cash. Large redemptions, especially in market downturns, can force the fund to either sell stocks for the cash, which generates a capital gains tax for everyone remaining in the fund, or the fund must keep a significant amount of cash for such redemptions, which means that it can’t be invested in stocks, or other securities that can earn a better return than the current interest rate. An investor of an ETF simply sells his shares to another investor on an organized exchange, just as he would sell a stock.
However, because funds based on the better known indexes are usually market-weighted, they may not be as diversified as one may believe, since these indexes have a greater weight in large-cap companies.
Fees are low, but so are many mutual bond funds, such as the Vanguard Total Bond Market Index (VBMFX) at 0.2%.
Bond funds don’t turnover nearly as fast as stock funds, and redemptions are much less for bond funds. Bond mutual funds might be a better investment than bond ETFs because of greater inefficiencies in the bond market that allow some bond mutual fund managers to consistently beat the indexes.Microcap ETFsMicrocap stocks have a low correlation with large cap stocks, and thus, micro-cap ETFs represent a good way to diversify a large-cap fund with stocks that have an overall greater growth potential. Investors who hold a foreign dividend-focused fund in a taxable account can claim a foreign tax credit on their U.S. This credit, however, is not available if the fund is in a tax-deferred account, since if no federal taxes are paid, then no credit can be taken.American stocks paying high dividends are concentrated in a few sectors, such as utilities and financials, while foreign stocks that pay high dividends are more diversified, including media and technology companies. However, short-term trades cause extensive buying and selling of the securities as arbitrageurs try to take advantage of these differences in prices, which some critics contend causes wild market gyrations at the start and end of the trading day.
Some funds, for instance, track nanotechnology companies or homebuilders, or target specific countries or regions, such as Australia, Austria, or South Africa.

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26.11.2013 | Author: admin

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