Exchange Traded Funds (ETFs) 101

Exchange Traded Funds (ETFs) have garner investors'attentions and affections for years in the United States. The numbers of ETFs grew significantly in 2003.....

Venus Fan 19 May, 2008 | 0:00
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Exchange Traded Funds (ETFs) have garner investors'attentions and affections for years in the United States. The numbers of ETFs grew significantly in 2003. The growth rate has been substantial ever since 2005 with the numbers grew by two or three folds annually. In the past 18 months, there are around 300 ETFs launched with total asset under management of 587.8 billion as of March, 2008, compared to 110.5 billion as of April, 2007; asset under management growth rate has risen at 40% year to year. However, most assets are still accumulated in few dominant fund houses that launched ETFs. For instance, Barclays Global Investors with its iShares series had total asset under management of $400 billion as of December

2007. Taiwan has caught up with the vogue as well. Although there are only ten ETFs currently traded on its exchange market, seven of them were recently launched (late 2007 and early 2008) with the exception for P-Shares Taiwan Top 50, the first ETF in Taiwan, which incepted in the year of 2003. Nonetheless, local investors have shown fair interests in the ETFs as their total asset under management reached $1.7 billion at the month of February, 2008. The followings are basic features of the ETFs for your further reference.

The number of ETFs launched for the past five years in the United States and Taiwan

Data Source: Morningstar. Data as of May 12nd, 2008

What are Exchange Traded Funds (ETFs) ?

Exchanged Traded Funds as their name implies are baskets of securities that are traded on exchanges. Just like closed-end funds and stocks, ETFs can be bought and sold throughout the trading day on an exchange. Anything you can do with stock, you can do with an ETF. As long as you have a trading account with any licensed brokerage firm, you can begin to the transaction through your broker.

Costs: ETFs are passively managed with lower expense ratio

EFTs are known for their index tracking performance by passive management in contrast to other mutual funds which aim at outperforming the market through active management. The fund managers of ETFs do not select securities for their portfolios but track the composite closely. These fund managers only change their holdings according to the composites.

Passively management makes ETFs induce relatively low management fee compared with actively management funds. In addition, the relatively low turnover rate for portfolio holdings also enables ETFs transfer less cost to you from holding different stocks and reduces the overall expense. ETFs are considerably less expensive than vast majority of mutual funds. Case in point, the annual expense ratio for iShares S&P 500 index is 0.99% while average annual expense ratio for mutual funds is 1.5% and above in the States. As for Taiwan, the annual expense ratio for mutual funds ranges from 1.2% to 1.6% with balanced funds records around 1.10% and bond funds registers around 0.40%. The annual expense ratio for ETFs is significantly lower, ranging from 0.32% to 0.40%.

Annual Expense Ratio between Mutual Funds and ETFs in Taiwan

Price & Performance: You do not have to hold multiple stocks to have an index return while ETFs pricing and transaction are similar with stocks.

ETFs are traded on exchanges so their transactions are pretty much the same with stocks. You can buy and sell ETFs through licensed brokers during trading hours. However, ETFs prices are different from the net asset values of mutual funds with which only one price for investors to buy and sell for the day. ETFs have different prices throughout the trading day as a result of the supply and demand in the market. The cost of transaction is the same with stocks in Taiwan, including transaction fee and securities transaction tax, also known as turnover tax. Nonetheless, turnover tax is lower for ETFs. While there is 0.3% turnover tax charged on trading a stock, it is 0.1% for trading an ETF. Turnover tax for trading an ETF is only a third of that for trading a stock.

From owning an ETF, Individual investor can reap the benefit of an index return without investing in multiple stocks from its index tracking performance. In addition, EFTs track various indexes and therefore broaden their investment universe in a wide spectrum, including geography, sectors and commodities such as iShares MSCI Taiwan Index that tracks MSCI single country index, PowerShares QQQ that tracks NASDEQ 100 and commodity index fund, StreetTracks Gold Shares.

Things to consider when investing in ETFs:
Price and Performance: ETFs can be traded at discount value during trading hours; their performances are mostly likely to duplicate the indexes, not to outperform them.

Due to supply and demand in the market, ETFs price is likely to fluctuate throughout the trading day. ETFs are traded above or under the net asset value of their underlying holdings during the trading hours. Notably, as an ETF aims at duplicating a tracking index and its return accordingly, the vast majority of ETFs does not outperform their tracking indexes nor do they change their portfolios in light of market condition. When its tracking index posts a negative return, it is quite unlikely to see the ETF register a positive return instead.

Costs & Expenses: Trading ETFs frequently with small amount can incur more costs

The rule of thumb for fund investment is to seek a fund's long term performance. ETFs are no exceptions. Although ETFs do have lower expense ratio in comparison to mutual funds, various expenses still incur when trading ETFs, such as transaction fee. Despite the fact that each expense remains relatively low, the sum can be quite daunting if you trade ETFs frequently with small investment amount.

Risks: Be aware of Market Risk and Tracking Error.

When tracking indexes, ETFs assume market risk at the same time as the net asset value of their underlying holdings fluctuate with the ups and downs of the composite. While ETFs aim at tracking indexes, one has to bear in mind that their holdings are not exact the same as the composite's. Given the circumstance, the tracking error derives. Not only does it disable the performance of ETFs to reflect that of their tracking indexes but also does it undermine ETFs to meet the expected return of tracking indexes for investors.

Venus Fan can be reached at venus.fan@morningstar.com
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