| Exchange Traded Funds (ETFs) were first | | | | an investor to recognize income. When an ETF is |
| introduced to institutional investors in 1993. Since | | | | purchased, it establishes the cost basis for the |
| then they have become increasingly acceptable to | | | | investment on that particular trade for the |
| advisors and investors alike because of their ability | | | | investor. And given the fact that most ETFs |
| to allow greater control over the portfolio | | | | follow a low-turnover, buy-and-hold approach, |
| construction and diversification process at a lower | | | | many ETFs will be highly tax efficient with |
| cost. You should consider making them a core | | | | individual shareholders realizing a gain or loss only |
| building block to the foundation of your personal | | | | when they actually sell their own ETFs. |
| investment portfolio. | | | | 7. Lower Transaction Costs: Operating an ETF is |
| 1. Better Diversification: Most individuals do not | | | | much cheaper than a mutual fund. In a mutual |
| have the time or skill to follow every stock or | | | | fund, there are shareholder service expenses |
| asset class. Inevitably, this means that an individual | | | | which are not needed for an ETF. In addition, |
| will gravitate to the area he or she is most | | | | ETFs eliminate the need for research and portfolio |
| comfortable in which may result in investing in a | | | | management because most ETFs follow a passive |
| limited number of stocks or bonds in the same | | | | index approach. The ETF mirrors the benchmark |
| business or industry sector. Think of the telecom | | | | index and there is no need for the added |
| engineer working at Lucent who bought stocks | | | | expense of portfolio analysts. This is why the |
| like AT&T, Global Crossing or Worldcom. | | | | average ETF has internal expenses ranging from |
| Using an ETF to buy a core position in the market | | | | 0.18% to 0.58% while the average actively |
| as a whole or in a specific sector provides instant | | | | managed mutual fund incurs about 1.5% in annual |
| diversification which reduces portfolio risk. | | | | expenses plus trading costs. |
| 2. Improved Performance: Research and | | | | To compare the total cost of owning an ETF with |
| experience has shown that most actively | | | | any mutual fund, the Financial Industry Regulatory |
| managed mutual funds typically underperform | | | | Authority (FINRA) makes available a Fund & |
| their benchmark index. With fewer tools, limited | | | | ETF Analyzer tool on its website. The calculator |
| access to institutional research and lack of a | | | | automatically provides fee and expense data for |
| disciplined buy/sell strategy, most individual | | | | all fund share classes and ETFs. The calculator can |
| investors fare even worse. Without having to | | | | be found at: |
| worry about picking individual winners or losers in | | | | 8. Trading Flexibility and Implementing |
| a sector, an investor can invest in a basket of | | | | Sophisticated Investment Strategies: ETFs trade |
| broad-based ETFs for core holdings and may be | | | | like other stocks and bonds. So this means that |
| able to improve the overall performance of a | | | | an investor has the flexibility to use them to |
| portfolio. For example, the Consumer Staples | | | | employ a range of risk management and trading |
| Select Sector SPDR was down 15% through | | | | strategies including hedging techniques like "stop |
| October 23, 2008 while the S&P 500 was | | | | losses" and "shorting," options not available by |
| down more than 38%. | | | | "long-only" mutual funds. |
| 3. More Transparency: More than 60% of | | | | Another advantage is the ability to use "inverse |
| Americans invest through mutual funds. Yet most | | | | ETFs" which may provide some protection against |
| investors don't really know what they own. | | | | a drop in value of the market or sector. (An |
| Except for a quarterly report showing the holdings | | | | inverse ETF responds opposite the return of the |
| as of the close of business on the last day of the | | | | underlying benchmark. So if one wants to |
| quarter, mutual fund investors do not really know | | | | minimize the impact of a decline in the S&P |
| what is in their portfolio. An ETF is completely | | | | 500 index, for example, then one can invest a |
| transparent. An investor knows exactly what it is | | | | portion of the portfolio in an "inverse" which will go |
| comprised of throughout the trading day. And | | | | up when the index value goes down.) |
| pricing for an ETF is available throughout the day | | | | Or an investor can tilt their portfolio to |
| compared to a mutual fund which trades at the | | | | "overweight" a particular industry or sector by |
| closing price of the business day before. | | | | buying more of an ETF index for that area. By |
| 4. No Style Drift: While mutual funds claim to have | | | | buying an index, an investor can be positioned to |
| a certain tilt such as Large Cap or Small Cap | | | | take advantage of the expected changes in this |
| stocks or Growth versus Value, it is common for | | | | industry or area without the inherent risks |
| a portfolio manager to drift away from the core | | | | involved with an individual stock. |
| strategy noted in a prospectus in an effort to | | | | Some investors become wedded to their individual |
| boost returns. An active fund manager may add | | | | stocks or mutual funds and do not want to sell |
| other stocks or bonds that may add to return or | | | | and incur a loss and miss out on the opportunity |
| lower risk but are not in the sector, market cap | | | | for an expected rebound. Another tax-efficient |
| or style of the core portfolio. Inevitably, this may | | | | option for an investor to consider is to sell the |
| result in an investor holding multiple mutual funds | | | | security that is at a loss while buying the ETF |
| with overlap exposure to a specific company or | | | | representing the industry or sector of the sold |
| sector. | | | | security. This way the investor can book the loss, |
| 5. Easier Rebalancing: The financial media | | | | take the tax deduction for it and still be positioned |
| frequently extols the virtues of rebalancing a | | | | in the area but with a more broadly diversified |
| portfolio. Yet, this is sometimes easier said than | | | | index. |
| done. Because most mutual funds contain a | | | | Investors, academics and financial advisers |
| combination of cash and securities and may | | | | sometimes question the strategy of "buy and |
| include a mix of large cap, small cap or even value | | | | hold." Some investors seek a more active |
| and growth type stocks, it is difficult to get an | | | | management tactical approach which can be done |
| accurate breakdown of the mix to properly | | | | with ETFs. Even though ETFs represent |
| rebalance to the targeted asset allocation. Since | | | | passively-created indexes, an investor can actively |
| each ETF typically represents an index of a | | | | trade them. There are a variety of trading |
| specific asset class, industry sector or market | | | | strategies available to "manage the trends." When |
| capitalization, it is much easier to implement an | | | | an index moves above or below its 50-day |
| asset allocation strategy. Let's say you wanted a | | | | moving average or 200-day moving average, this |
| 50/50 portfolio between cash and the total US | | | | may be a signal to trade in or out of the ETF. To |
| stock market index. If the value of the S&P | | | | minimize the trading costs that would be incurred |
| 500 (represented by the SPDR S&P 500 ETF | | | | by trading an ETF, an investor can use an ETF |
| 'SPY') fell by 10%, you could move 10% from | | | | wrap program that covers all trading costs. |
| cash to get back to the target allocation. | | | | Typically, such arrangements are still less costly |
| 6. More Tax Efficient: Unlike a mutual fund which | | | | than buying or selling multiple individual stocks in a |
| has embedded capital gains created by previous | | | | separately managed account or using an actively |
| trading activity, an ETF has no such gains forcing | | | | managed mutual fund. |