The In’s and Out’s of ETF Trading

Posted by admin as shares and stocks

In the investing world, exchange traded funds (ETFs) are the latest and greatest. Although they’ve been available for more than 10 years, it wasn’t until recently that the popularity of ETFs took off.

ETFs trade on the stock exchange as if they were stock. Usually they followed an index like the Dow Jones or NASDAQ. Recently, however, they are putting together ETFs that have a characteristic in common: they invest in a region or sector of the market, or have a certain market capitalization.

There are many advantages of ETFs over open and closed mutual funds. They are inexpensive to get because, like when purchasing stocks, you are paying a commission. If you use a discount brokerage you can purchase for little money. The regular maintenance fees for an ETF are also small when compared to managed mutual funds, and sometimes lower than index mutual funds.

Because ETFs trade like stock they have liquidity. With a simple phone call you can buy or sell. ETF exchange traded funds are priced every 15 seconds and trade continually throughout the day. This is not like mutual funds because mutual funds are only bought and sold at the end of the day. Since the exchange traded fund will be kept in a brokerage, it can be traded easily.

Tracking an index means less selling within the fund. This makes for a tax efficient fund. It is rare that an ETF declares a capital gain distribution. You choose when to sell and, as a result, you determine when you pay the taxes.

Index and managed funds keep some of their assets that are investable in cash. This is used to pay someone that is promoting their fund. Because ETFs trade like stocks, there is no need to keep a portion in cash.

There is no room for style drift in an ETF. In an actively managed mutual fund, the fund can say it is a large cap fund, but may chase performance by investing in small or mid caps at times. Exchange traded funds are required to keep a 99% correlation with the index or collection of stocks that it represents.

Regarding ETF trading strategies, because ETFs trade like individual stocks you have the additional features of stock. Exchange traded funds can be sold on margin or short. They can have limit, buy and stop loss orders for buying and selling. Call and put options can be bought and sold using exchange traded funds.

There are of course disadvantages to ETFs as well. They are not an appropriate investment to use with dollar cost averaging. If you have to pay a $10.00 fee each month when you make that $50 or $100 investment it can be difficult to make up that fee.

With the explosion of ETFs you have to watch what the fund is using as its underlying stocks. Sometimes it can be such a narrow focus that you really are not achieving diversification.

Due to the ease of trading you can get caught up in riskier strategies than you want. Short term trading and market timing can result in significant losses. Buying and selling ETF puts and calls, or buying on margin, is speculating and is riskier than buying and holding.

Exchange traded funds are the right choice under certain circumstances. You can use a broad index ETF as a core holding. This can be supplemented with targeted ETFs to provide weighting in a particular sector, region or type of market capitalization. As always know what you are investing in and be sure that it fits in your portfolio.