Spiders, Diamonds, Cubes, Opals…You’ve heard the names being tossed around in various circles; you may even know what they are. We’re talking about ETF’s or Exchange Traded Funds. What exactly are they? How do they differ from mutual funds, and are they appropriate for your portfolio? We’ll take a closer look at what ETF’s are all about, their advantages, disadvantages, and hopefully a clearer understanding will emerge to help answer the question, “Are ETF’s suitable for my investment portfolio?”


What are ETF’s? ETF’s, an acronym for Exchange Traded Funds, are an investment-based product, which allow an investor to buy or sell an entire portfolio of stocks in a single security. For example, the QQQ’s, or “Triple Q’s” are an ETF, which allows an investor to purchase the entire Nasdaq100 Index through a single security. This is an example of a Broad Based ETF. There are Sector ETF’s which track specific sectors, and there are International ETF’s, which track stocks of individual countries. The philosophy behind ETF’s is similar to mutual funds in that they are designed to provide diversification, as well as the ability to purchase a ‘basket’ of stocks without having to purchase every individual stock in a specific sector, market, etc. Many ETF’s are very similar to Index Funds in that they essentially are a basket of stocks within an index.

ETF’s are similar to mutual funds in theory, but differ in many ways. ETF’s trade like a stock therefore can be purchased on the open market throughout the course of the day. Mutual funds, however, typically price once per day and an investor much purchase or sell at the closing net asset value daily. The ability to trade ETF’s during the day make for a more liquid position, providing the underlying stocks are liquid as well. For the more experienced investor, ETF’s can be bought on margin, can be sold short, and options are available. This is not the case with mutual funds.

ETF’s will never “beat the index” as you are essentially buying the index. For example, an investor purchases Diamonds, (DIA). When an investor purchases Diamonds, which track the Dow Jones Industrials, he/she is essentially ‘buying the Dow’ and therefore will not “beat the Dow” with this approach. A mutual fund differs in that it is actively managed where ETF’s are passively managed. A mutual fund manager can alter the portfolio to enhance returns, and ‘beat the index’. An ETF’s portfolio is the index and cannot be changed.

Another exciting characteristic of ETF’s is the “Tax Appeal.” When mutual fund managers buy and sell positions within a mutual fund, the event is taxable, and this tax burden is passed on to the mutual fund holder. ETF’s never selling a position, which virtually eliminates any taxable income.

ETF’s are fully invested at all times, so there is no cash position, which can drag down the return of a mutual fund. The lack of a cash position also eliminates the need to distribute interest on a monthly basis.

There are no sales loads for an ETF, unlike mutual funds, which charge up to 5% of an investor’s initial purchase as a sales charge. However, in order to buy or sell an ETF, you’ll need to contact your broker, and be subject to any commissions on the transaction. Keep in mind that with mutual funds, your sales charge pays for service, marketing materials and other benefits not recognized with ETF’s. Remember, you get what you pay for. Although ETF’s are considerably less costly to an investor, it is exactly like purchasing a stock and an investor should perform due diligence prior to dabbling in Exchange Traded Funds.

You might be wondering who manages ETF’s. There are various financial institutions, which manage them. The Bank of New York manages the QQQ’s (Nasdaq100), Barclays manages iShare products, Merrill Lynch manages HOLDRs, and SPDRs (Spiders) are managed by State Street Bank and Trust or the Bank of New York. Again, they are passively managed which means an initial purchase is made to create an ETF, but there is very little trading after this. To create SPDR’s, QQQ’s, Diamonds, and Select Sector Funds for example, a unit of 50,000 shares is required. For Mid Cap SPDR’s a unit of 25,000 shares is required.

In summary, the primary reasons for an individual to consider ETF’s are as follows. Tax efficiency, trading & tax Flexibility, lower expense ratios, diversification, investing in an entire market sector, access to sectors/indices not available with mutual funds, and continuous pricing. Some of the most popular and actively traded ETF’s are QQQ (“Triple Q’s” track the Nasdaq100), SPDR (“Spiders” track the S&P 500), and DIA (“Diamonds” track the Dow Jones Industrials). A great place to research and learn more about ETF’s is at www.nasdaq.com and www.amex.com.

If you’re a more experienced investor and are comfortable purchasing your own mutual funds and stocks, etc, it may be a great time to re-balance your portfolio and diversify with Exchange Traded Funds.

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