Entries Tagged 'Economics and Investing' ↓

(part 2 of 3)

You’ve seen what ETFs are in part one of this series. Now we’ll look at the pros and cons of buying these “poor man’s derivatives.”

The advantages of exchange traded funds

ETFs beat mutual funds when it comes to costs. Even with paying both commissions on buying and selling and fees, ETF costs will usually be lower than a mutual fund.

Besides lower prices, the presumed advantages of ETFs are that they are more diversified than mutual funds. After all, a whole country or even an entire region of the world is much broader than a stock or a mutual fund.

ETFs have an advantage over stocks of being much simpler to invest in. Investment in stocks requires knowledge of companies, industries, and if you’re a technical trader, of all kinds of technical indicators of the health of a company and the industry it belongs in. ETFs only require a basic knowledge of the stock index index that ETF is based on.
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Once upon a time long ago in a land faraway, there was a community of successful business people who wanted more books to read. They decided to pool their resources and create a brand new library.

These people founded a beautiful new library building in the center of their city. They sought the best librarian in the land, so they offered the extra incentive of fees. In addition to a salary and bonuses, their librarian could earn fees for services. They instructed their librarian to uphold two of Mr. S.R. Ranganathan’s “five laws of library science”:

A book for every reader.
A reader for every book.

Our industrious librarian immediately began making deals with both book publishers and library patrons, charging each side a fee. These deals were all based on the value of books. So these kinds of deals quickly become labeled “book derivatives,” or “BODs” for short.
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(part 1 of 3)

In my post, Fees in a Mutual Fund Prospectus: Three Ways A Prospectus Deceives, part 3,  we looked at how mutual fund fees can accumulate and take more than half of the total return on your investments. Over the past seventeen years many people realized this loss on mutual funds was happening. They’ve switched to investing in exchange traded fund (ETFs) instead.

Investors have caused the number of exchange traded funds to nearly double over the past few years.  Should you think about joining them? Well, yes, consider ETFs, but be aware of how complex these derivative products are.

Derivative products have no value of their own. Their value is based on other kinds of investments. Exchange traded funds are based on the value of a “basket” of stocks that are owned by an entity called a “market maker.” You buy rights to part of this virtual basket when you buy an ETF.

In this post we’ll see what an ETF is. In part two of this series on ETFs we’ll look at pros and cons of buying an ETF. In part three we’ll learn about market makers of ETFs and what risks are entailed in buying ETF products from them. Continue reading →