Exchange Traded Funds
Exchange Traded Funds – an Overview
Exchange-Traded Funds, or ETFs, are index funds that trade just like stocks on the major stock exchanges. (In a lot of ways they’re mutual funds only – you guessed it – different.)
All the major stock indexes have ETFs based on them, including:
- Dow Jones Industrial Average
- Standard & Poor’s 500
- NASDAQ
In effect, an ETF is like a basket of stocks or asset classes. There are ETFS for large companies, small companies, international stocks, bonds, commodities like gold – think of an asset class and the likelihood is high that asset class is represented by an ETF.
Here’s a quick example: Say you don’t want to invest in individual stocks, but want an investment that mirrors the performance of the S & P 500. Instead of investing in a mutual fund or, heaven forbid, purchasing stock in all 500 companies, you could invest in the S & P 500 ETF, the first and still the biggest ETF. It tracks the S & P 500 – and since it’s an ETF, you can buy and sell shares at any time.
The S & P 500 ETF was the first fund created, but it’s certainly not the last. Over the years, ETFs have been created to mirror many different themes:
- Broad market: Dow Jones, S&P 500, Wilshire 5000, Fortune 500
- Industry sectors: Cyclical, retail, transportation, natural resources, oil service, basic materials, chemical, technology, financial, pharmaceutical, real estate
- Size: Small cap, mid cap, large cap
- Region: Pacific, Europe, etc
- Investment style: Value, growth
- International markets: Australia, Austria, Belgium, Brazil, Canada, France, Germany, Hong Kong, Italy, Japan, Latin America, Malaysia, Mexico, Netherlands, Singapore, South Korea, Spain, Sweden, Switzerland, Taiwan, United Kingdom
And some ETFs utilize more than one theme; for example, broad market international, small cap growth, large cap value, etc.
The point is, if you’re looking for an asset class or investment style, an ETF likely exists to meet your needs. And they continue to grow in popularity. Last year, over half the volume on the American Stock Exchange was made up of ETF trades. Today there are over 800 ETFs, and that number will continue to grow.
Why Invest in ETFs?
Exchange Traded Funds provide two basic advantages. ETFs offer the diversification and relative security inherent in a traditional mutual fund – while giving investors the freedom to buy and sell ETF shares just as they would in a publicly-traded company. Plus, ETFs also generally carry low expense ratios, low turnover, and an advantageous tax structure.
As a result, an ETF lets you buy or sell what is, in effect, an entire portfolio of stocks by purchasing a single security – it’s as easy as buying or selling a share of stock. An ETF offers diversification through a wide range of investment opportunities while providing significantly greater flexibility than a mutual fund.
Think of it this way. Traditionally, investors have invested either by purchasing individual stocks or by investing in mutual funds. Mutual Funds are generally the equity investment of choice for smaller investors, but many substantial investors indulge in them as well. Why? Purchasing stocks in individual companies does not give the average investor enough diversification; buying shares in mutual fund lets an investor own a pooled investment containing a large number of stocks.
But while mutual funds do offer benefits to the average investor, they still aren’t an ideal equity investment.
Enter Exchange Traded Funds.
To show you the differences, here’s a comparison of mutual funds, individual stocks, and Exchange Traded Funds. (Or if you prefer, skip to the end of the section and we’ll sum up those differences.)
Diversification
ETF: A buyer of ETF shares gets instant diversification in the market or sector portfolio of stocks of his or her choice. By participating in a portfolio of a large number of stocks, an investor automatically enjoys ownership of a broad number of companies. This diversification provides a degree of protection in the event the price of one company in the index or sector should decline significantly.
Mutual Fund: Similar to ETFs.
Individual Stocks: To achieve reasonable diversification, requires ownership of ten to twenty stocks spread across different industries and market sectors.
Trading
ETF: ETFs can be bought or sold as easily as shares of individual stocks. Shares may be bought or sold at any time during the trading day while markets are open. Pricing is continuously updated. Purchases and sales settle three days after the transaction is completed, just as with individual stocks.
Mutual Fund: Typically only bought and sold at the end of the trading day after the market is closed (not intra-day) and are priced at net asset value. Purchases and sales settle immediately.
Individual Stocks: Same process as ETFs.
Dividend Reinvestment
ETF: Each ETF establishes its own dividend policy. Some immediately reinvest dividends. Others reinvest dividend payouts quarterly. A small percentage pays dividends in cash to shareholders.
Mutual Fund: Dividends may be reinvested in shares at the time of payment by the fund (typically quarterly) or may be paid out to shareholders.
Individual Stocks: Companies paying dividends make payment in cash, almost always on a quarterly schedule. Some companies offer a dividend reinvestment program (known as a DRIP) where a shareholder can elect to receive shares of stock instead of cash dividends.
Availability of Margin
ETF: ETFS may generally be purchased on margin under the same rules that apply to individual stocks.
Mutual Fund: Margin purchase of mutual funds is not available.
Individual Stocks: Many, but not all, individual stocks may be purchased on margin (based on your financial situation and the guidelines and policies of your broker.)
Short Selling
ETF: Eligible for short trading; the investor borrows shares from the broker in anticipation of declining market prices, hoping the shares can be bought back at a lower price. Some ETFs are exempt from the rule requiring shares to be sold short only when the last sale price is higher than the preceding sale.
Mutual Fund: Short selling not available with mutual funds.
Individual Stocks: Short selling available on most stocks.
Tax Efficiency
ETF: Ownership in an index results in much lower share turnover than most actively traded mutual funds. Investors do not experience the tax consequences from frequent purchases and sales of stock. In general terms, there are no tax consequences to ETF investors – even if the price of those shares rises dramatically – until the investor actually sells those shares.
Mutual Fund: Index-based mutual funds also have relatively lower portfolio turnover. But, managed funds with a high degree of purchase and sale activity can create significant tax consequences for shareholders.
Individual Stocks: Tax consequences only apply when individual stocks are sold and gains and losses are realized.
Cost
ETF: Although small trading fees are required, ETFs usually cost much less than a mutual fund since ongoing management fees are typically much lower. Annual management fees typically range from 0.1% to .7%. Relatively speaking, an ETF typically charges fees similar to or lower in cost than a no-load, index-based mutual fund.
Mutual Fund: Some mutual funds charge a sales “load” or fee which can often be as high as 4.5%. That fee is in addition to the management fee all mutual funds charge. At most mutual funds the management fee charged is considerably higher than the fee charged by ETFs; some mutual funds charge more than 2% per year.
Individual Stocks: The cost of ownership is based on broker commissions to buy and sell individual stocks. As a result there are no annual management fees.
Brokerage Availability
ETF: All ETFs can be purchased through any broker, whether the broker is full-service or discount.
Mutual Fund: Most no-load mutual funds can only be purchased through the company offering the fund. Load funds, typically funds with the largest fees, are available from most brokers.
Individual Stocks: Individual stocks, as with ETFs, are available through any broker, whether full-service or discount.
Options Availability (Including Covered Calls)
ETF: More and more Exchange Traded Funds offer options, allowing investors to write covered calls.
Mutual Fund: Options are not available on mutual funds.
Individual Stocks: Many individual stocks offer options, including the potential for writing covered calls.
Time Required for the Investor to Manage
ETF: Perfect for investors who do not have the time, interest, or knowledge to research and select individual stocks and actively manage their own portfolios.
Mutual Fund: Also ideal for investors who are short on time or who do not have the desire to research and select individual stocks.
Individual Stocks: The most time-consuming and potentially risky strategy for investors who do not research and select the right stocks and who do not diversify holdings sufficiently.
Investment Transparency
ETF: ETFs are completely transparent; you always know what stocks comprise the portfolio of an ETF.
Mutual Fund: Almost all mutual funds only report their actual holdings twice a year; investors seldom can determine exactly what they own.
Individual Stocks: Investors who purchase individual stocks always know what they own.
Price Volatility
ETF: Because they are made up of stocks from entire markets or market sectors, ETFs have lower price volatility than any of the individual securities that make up that fund.
Mutual Fund: Lower volatility individual stocks.
Individual Stocks: Volatility is specific to the individual stock. Individual stocks are inherently more volatile than a portfolio consisting of many stocks.
Suitability for Dollar Cost Averaging
ETF: Investors who wish to invest small amounts of money on a regular basis (often referred to as dollar cost averaging) should not choose ETFs. Purchasing additional shares creates a brokerage commission; making a number of small purchases can add up to a significant amount of broker commissions. To minimize commissions, purchase ETFs in 100-share lots, which is also the ideal size for writing covered calls.
Mutual Fund: Provide the best opportunity for investors who wish to make small, multiple purchases. With no-load funds, brokerage commissions are not paid if the shares are purchased directly from the fund itself.
Individual Stocks: Similar to ETFs; commissions apply to each transaction.
What are the main advantages to investing in Exchange Traded Funds?
- Allow a small investor to build an equity portfolio
- Increased diversification
- Lower administrative and management costs
- Ability to trade at any time
- Ability to trade on margin
- Ability to sell shares short
- Minimal tax consequences until profits are realized
- Require minimal time to research and track
And most importantly
- Exchange Traded Funds allow investors to write covered calls!
Writing Covered Calls with Exchange Traded Funds
Our covered call strategy is based on investing in Exchange Traded Funds. It is elegant in its simplicity and power-packed in its potential for the average investor.
Our covered call strategy involves two simple steps:
1. Use of Exchange Traded Funds as the investment vehicle of choice to obtain the requisite diversification needed by equity investors, and
2. Use of covered call option writing in conjunction with Exchange Traded Funds to yield consistent double-digit returns on investment.
How? Using Exchange Traded Funds, both novice and the seasoned investors can achieve portfolio diversification as well as focus – such as broad market, industry sectors, regions, investment styles, or international – without needing to develop personal expertise in financial analysis and stock selection techniques.
And you won’t have to devote huge chunks of time to researching individual stocks.
By writing covered calls on ETFs you own, enjoying consistent double digit returns is possible, even in a market where total returns from capital appreciation and dividends alone may be lower.
