Exchange Traded Funds (ETFs): Safe? or Risky Derivatives?

(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.

What are exchange traded funds?

Exchange traded funds are a “hybrid” investment. They possess some characteristics of stocks. They share other characteristics with mutual funds.

Like stocks, ETFs trade on exchanges such as the York Stock Exchange (NYSE). You pay a commission (usually under $10 these days) to buy them and a commission when you sell them. You can buy and sell any time you want. They are sold by both mutual fund companies and brokerage firms. And yes, they can be part of your retirement fund.

Like mutual funds, ETFs have fees. But these fees are usually far lower than mutual fund fees. Vanguard has even begun offering low fee exchange-traded funds with no commission charges on buying and selling. Unlike mutual funds you don’t need to wait until the end of the day to see the value of your ETFs. ETFs trade all day just like stocks do.

Exchange traded funds are cheaper than mutual funds because, until recently, none of them were managed funds. Instead of a manager, most of these funds simply reflect a stock index. You’ve heard of stock indexes such as Standard & Poor’s 500. The S&P 500 index, now owned by the McGraw Hill Companies, covers the 500 leading companies in leading industries of the U.S. economy.

There are hundreds of these stock indexes. As a result there are hundreds of “indexed ETFs” based on stock indexes. In this country there are around 900 ETFs available for trade. You can even buy an ETF that reflects a basket of stocks for a whole country anywhere in the world. It’s fun to own “Canada” or “Malaysia” or “Brazil.” But there are risks involved too.

We’ll look next at the pros and cons of buying these kinds of “poor man’s” derivatives. Following that we’ll examine the types of risks involved with trading ETFs.

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://brucenomics.com/.