The BAPKIN Plan

What’s an Exchange-Traded Fund (ETF)?
One of the greatest ways to invest passively in domestic and foreign markets is by making use of exchange-traded funds. Exchange-traded funds are quickly growing in popularity for investors because they provide flexibility and diversification with costs significantly lower than actively managed mutual funds. So what is an ETF?

Most of us are familiar with mutual funds. Mutual funds are “open-ended,” meaning that we can buy and sell each day at the net asset value of the portfolio as of the end of the day. Our monies flow directly to and from the portfolio with each transaction. The advantage of open-end mutual funds is that you receive the net asset value of what the investment is worth. There is no discount.

The problem is that you are getting the price at the close of the day, but you had to put your order in earlier in the day. Normally it’s not a big deal, but imagine if you put your order in to sell your fund in the morning when the markets were up 1 percent but during the day, news came out that caused the market to sell-off, and it ended up down 3 percent at the close. Having to wait for end-of-day pricing “cost” you 4 percent. It does happen, but not too often.

There are also “closed-end” mutual funds. These funds do not receive or pay out cash each day. Instead, they initially receive their cash to invest by issuing shares on the stock market and then go about their business managing the money in the portfolio. You want to invest in the fund or get your money back? Not the fund’s problem – it’s up to you to buy shares or sell the shares you own in the stock market, and you would pay a commission to do so each time, as you would any stock that trades on an exchange.

The advantage of closed-end funds is that you can sell or buy at market prices throughout the day without having to worry about end-of-day pricing. A typical problem with closed-end funds is liquidity. Unless there are many other investors who want to buy or sell the security, there tends to be a sizeable gap between the bid that someone is willing to pay (likely this is what you’ll get if you want to sell) and the ask that someone wants to receive (this is typically what investors will pay if they really want to buy). I’ve seen these gaps be as large as 5 percent.

The closed-end fund is also usually actively managed, and the management fee can be as high as it is for an open-end mutual fund. They often only price their portfolio periodically, such as weekly, so much of the time you don’t really know the true net asset value of what you are buying and selling.

Enter the exchange-traded fund. The exchange-traded fund operates similar to the closed-end fund, except it usually is not actively managed and it charges a low management fee because of that. Most of the ETFs out there represent an index or investment theme. For example, the Standard and Poor’s 500 is a closely followed American index representing five hundred of some of the largest corporations in the United States. But an index is not an investable security - it is a fictional basket of stocks with no fees and no trading costs - yet many investors find that they cannot outperform the index and would gladly receive a return which approximates it. So an ETF was established that invests in a basket of stocks designed to mirror the return of the S&P500, minus a low management fee. Voila, investors have an approximate way to invest in the index.

A big advantage of the more popular exchange-traded funds is their liquidity – they will typically trade one penny apart on the bid and ask, and most are priced every day, so you know what their net asset value approximates. They are available representing so many different markets, indices, and investment sectors. Some hedge foreign currencies, while others do not and they aren’t just available for stocks. There are also ETFs that represent bond indices and inverse market returns, amongst other areas.

The list of ETFs is growing every year. With that come a few pitfalls. The more ETFs that become available representing similar investments, the greater the potential reduction in liquidity. Also, investors often blindly invest in ETFs without understanding what they are comprised of, but ETFs often don’t provide as much diversification as you might believe and so need to be understood. For example, Nortel once represented 37 percent of the Canadian market. Imagine if you came into my office and I said to you “I’m going to put about 40 percent of your money in one stock, and the rest we’ll diversify around.” You’d think I was crazy, yet this is often how some indices and ETFs are weighted. I remember Mexico at one point having three stocks representing almost half of its index. You need to understand these risks and do some homework before you invest.