ETF Investing (Part 1)

This is the first in a series of posts that explores investing in ETFs. I am sure most of you have heard about ETFs (Exchange Traded Funds) - which are the hottest and fastest growing financial instruments of recent times. Almost every few days I hear about the launch of a new ETF, the most recent one that caught my eye was the Nuclear Energy ETF by Market Vectors. Some of the early (and most popular) ETFs include the PowerShares QQQQ (based on Nasdaq 100 index), AMEX SPY (based on the S&P 500 index) and the AMEX DIA (based on the DJIA). Yahoo Finance today reveals a total of 565 ETFs trading in US markets.

What are ETFs?
ETFs are like mutual funds, or more specifically index funds, that trade like stocks, on the open markets. However, unlike mutual funds, the price of an ETF fluctuates throughout the day based on supply and demand. ETFs combine the diversification of mutual funds with flexibility of stocks. Interested in owning the entire US stock market? - you have the Vanguard Total Stock Market ETF (AMEX: VTI) at your disposal. Bullish on technology? - you have sector specific ETFs like the Morgan Stanley Technology ETF (AMEX: MTK). Want to allocate a bigger slice of your portfolio to emerging markets ? - go for the iShares MSCI Emerging Markets ETF (AMEX: EEM).

How do ETFs work?
In order to understand the tax-advantage of ETFs, it is very important to understand how they are created. The big mutual fund companies own a lot of individual shares of different companies as underlying part of mutual funds. So, if they decide to establish say, one unit of the S&P500 ETF, they go an authorized entity with a basket comprising of individual shares of the S&P 500 index and the authority redeems these shares for one unit of the ETF. Of course, these baskets are typically quite huge, and get redeemed typically for 50,000 or more units of the ETF. These ETF units are then floated on the open market for others to buy and sell.
Redemption is exactly the reverse - an S&P 500 ETF can be redeemed by the ETF company for an equal number/proportion of stocks.

Advantages of ETFs

• Cost: Probably the biggest advantage of ETFs is the cost factor. Since ETFs are passively managed, their expense ratios are very low compared to traditional mutual funds. Of course, you do have to take the trading commissions into account since you buy ETFs through a brokerage account. However, trading commissions can be zero these days if you have a Zecco brokerage account.
  
• Tax advantage: Mutual funds typically are actively managed, and result in large turnovers of the underlying stocks, which result in unnecessary capital gains taxes for all individuals, irrespective of whether the individual chooses to sell his own fund. Due to the very nature of ETFs (read above for how they are created and redeemed), the capital gains taxes need to be paid only at the final sale of the fund.
• Diversification: ETFs are a handy way to create a diversified portfolio consisting of different indices and hence mitigate the risk of owning an individual stock.
  

Where can I buy ETFs?
Since ETFs trade like stocks on the open market, all you need is a brokerage account. You can discount brokerage accounts with very low or zero trading commissions at brokerages like ScottTrade, Izone, ShareBuilder, FirstTrade and Zecco (free).

ETF Resources:

• ETF Center at Yahoo Finance
• ETFConnect.com
• Morningstar ETF section
  

Stay tuned for more posts on ETFs about portfolio allocation, comparison of the different fund families and more.

Part1
Part2
Part3