RSS feedI realized that, in my last few posts on emerging markets, my suggestions for how to play opportunities in these markets often revolved around Exchange Traded Funds (ETFs) or, in the particular case of India, an exchange traded Closed-Ended Mutual Fund. These may be confusing terms to people who have not invested before and I think it’s time to take a break from the “Emerging Markets” series and concentrate a little bit on examining exchange traded products. To tell you the truth, I think exchange traded investments may be confusing regardless of investment experience as I have heard all sorts of gobbely-gook about exchange traded products these days, particularly ETFs, and I think its time for me to take a shot at setting the record straight.
First, let me define what I call exchange traded investments are securities which are traded on stock exchanges that don’t necessarily represent stocks in a company. These include ETFs, closed ended funds, exchange traded notes (ETNs), and Holding Company Deposit Receipts (HOLDRs). Outside of HOLDRs, investments in these types of products behave exactly like investments in stocks. You can buy them long, short them, use advance trades on them like limits and stops, etc. The investments, however, typically represent, in a real or metaphorical way, an underlying investment in other stocks. Essentially these exchange traded investments act as a medium to gain access to the returns of a basket of other investments. This structure saves you excess commissions as you only need to place one order to buy the basket while also providing you access to the basket even if you don’t have the funds to purchase every security represented by the basket.
The above description probably sounds very similar to mutual funds and that is probably why exchange traded investments, particularly ETFs, are so inappropriately compared to mutual funds. The description of “ETFs beating mutual funds this year” or popular CNBC spots on the attractiveness of ETF expense fees relative to mutual funds seems to lead many people new to ETFs to believe that ETFs are simply highly liquid, low-expense mutual funds. What a wonderful world we would live in if this was true. But, alas, it is untrue. Exchange traded investments are wildly different from mutual funds and really shouldn’t be considered as an alternative to mutual funds (except maybe sector and index mutual funds).
Exchange traded products are not a set it and forget it investment like open-ended mutual funds are. For example, people typically buy a mutual fund based on the manager or the company which runs the fund. They believe that this company or manager has an ability to pick stocks better than them and thus give them money and wait for the returns. While part of the appeal is the ability to pool funds and get exposure to a larger base on investments, the main appeal is that the money is being cared for by professionals. Exchange traded products, for the most part, do not offer this peace of mind. Yes, they offer diversity and access to all sorts of different kinds of investments, but they typically are meant to track the performance of a pre-defined basket of stocks and are passively managed if not completely static. It is not accurate to say something like “exchange traded funds beat mutual funds this year” as they are not managed for the same purpose.
As a result of the more passive management structure in exchange traded investments, fees are typically lower than standard, open-ended mutual funds but they do take more work to understand. All this may sound confusing, in actuality, not all exchange traded investments are created equal and some of the generalizations I’ve made above are not true for all of the types of exchange traded investments that I mentioned in the first paragraph. Over the next week I’m going to take some time to get into exactly what exchange traded products are out there, describe them and what they offer to the retail investor (you and me), with a closer look at exactly what these exciting investment products are, you’ll be able to invest in them confidently and make good decisions when choosing between exchange traded products and open-ended mutual funds.
