ETF's - Exchange Traded Funds - Are They Right For You?

What is an ETF?:- An ETF is similar to a mutual fund in as much as it represents an investment in a collection of stocks, bonds, commodities etc, but with one significant difference - it can be traded on the stock exchange. 

To illustrate this difference more clearly, it helps to understand what happens when you buy units in a mutual fund. The price of these is based on the net asset value of the fund, which is calculated once a day. No matter what time of day you buy, you're getting a fixed price for that day. ETF's also have a daily net asset value, but the shares can differ in price throughout the day, which provides an opportunity to buy and sell at a profit. If the shares are trading below net asset value they are said to be at a discount, and if they're above NAV, they're trading at a premium.

Most ETF's are index trackers - they hold securities that mirror those that make up the index itself, the objective being to replicate the performance of that index. The advantage of this from a trading perspective is that it gives the trader an opportunity to benefit from intraday index moves by buying or selling ETF shares accordingly. Or he/she can take a longer term position if that's the preferred strategy.

ETF's have been around in America since 1993, with the introduction of the SPDR (Spider), which tracks the S&P 500 index. Since then the number of ETF's in the U.S. has grown to over 1500. ETF's came to Europe in 1999.

Types of ETF's: - the most popular ETFs are those that track indexes, like the SPDR mentioned above. In the UK they include the iShares plc FTSE 250 and the FTSE 100 UCITS. There are also Bond ETF's, which are seen as attractive investments in times of recession when the stock market is not so popular, and commodity ETF's, which hold investments in precious metals like gold, silver, and palladium. Agricultural and energy ETF's also fall into this category. Finally there are currency ETF's, which track the performance of all major currencies and some of the minor ones too.

Cost advantages: - Most ETF's are passively managed, which means the manager simply tries to replicate the relevant index by investing in a representative sample of the assets that make up that index. The passive manager is not trying to outperform the market, but is just attempting to replicate the performance of the index. A lot of this is done using computer modelling. This needs less hands on management, which results in lower fees. Active management on the other hand, which some ETF's are subject to, is an attempt to outperform the market. In this respect there is a similarity with mutual funds, and the charges are subsequently higher for ETF's managed this way. If you're contemplating an ETF investment, find out which style of management is in operation.

Generally however, ETF's have cheaper charges, averaging less than 1%, whereas mutual funds can range from 1% to 3%. Over time this becomes a significant difference.

In terms of taxation, the UK investor needs to be aware of the taxation status of any gains accrued from ETF investment. If the tax status is either 'reporting' or 'distributor' you'll pay capital gains tax. Otherwise it will be income tax, which can be much higher. Also bear in mind that any dividends received are seen by HMRC as income, and are treated as such. And remember that if your ETF was issued in another country you may be subject to the tax laws applicable there.

ETF's vs Mutual funds: - Some of the differences between these two have already been mentioned above, so the question here is, which one is right for you?

It depends on what kind of investor you are. If you like to be active in the market the ETF's offer you the opportunity to trade all day every day. You can go long or short as you wish. Management costs are usually lower, though if you trade a lot you need to take into account the costs of buying and selling.

If on the other hand you're more passive then mutual funds might be the better option. You buy at that day's price and hopefully watch your units increase in value, a process assisted by the ostensibly superior expertise of the fund manager. You might pay a bit more for the privilege of course.

In performance terms ETF's and mutual funds seem to be close. In researching the year to date returns for the top performing funds I can find figures for both mutuals and ETF's ranging from 16% to 100% for ETF's, and from 14% through 1,290% for mutuals! Would seem to give the lie to the often quoted opinion that professional fund managers tend to underperform. I would only add the also often quoted caveat that past performance is no guarantee of future performance either....

The ETF market has come a long way since its inception in the U.S. in 1993. There are ETF's to track just about every index around. With China and other emerging markets making their mark on the world economy, we are seeing ETF's coming through that are targeting this sector. At the moment, with the Chinese economy in a slower growth period, the year to date returns don't look impressive. But if you are a prospective investor in ETF's this could be an interesting and potentially profitable way to go longer term. The same principle applies to Brazil, Russia and India, the so called BRICs countries.

To conclude: - ETF's offer similar attributes to mutual funds, but give the more active investor the option to trade shares, with lower management fees and easy liquidity. You are free to hold onto your ETF shares long term if that is your preference, and it would seem that if you do you'll make returns comparable to mutual fund returns, without the higher charges. So in a sense it's the best of both worlds.

Fear And Greed - The Ongoing Battle For the Trader!

Let’s imagine a simply game, where participants are enticed to play it due to the potential rewards on offer. The players are not required to make anything useful, or provide any needed service, nevertheless a few of the participants, maybe less than 5 per cent of them consistently win at it reaping huge rewards.  Perhaps you are wandering how this could be; bearing in mind that in this hypothetical games no tangible products or services are being created. It occurs because the winners' profits are generated from the losers’ losses.  This type of game is known as a zero sum game, in which the winners, a small minority of the participants, enjoy huge profits from playing it, which incidentally equates to the losses of the other 95 percent of the participants. Put simply, Bob’s win is Jill’s loss.

Naturally, for this game to continue functioning it would need to draw in a constant stream of new participants, since many of the players would either give up, believing that they can’t make money out of playing it. Sadly, for a few they may even be expulsed by the game, playing it to the bitter end, kidding themselves that a big win was around the corner, but in realty finish up, penniless, hopeless and in the poor house.  

Now assuming the game has been deliberately designed to tap into the two most powerful human emotion; fear and greed. Then, new participants could be drawn into playing, enticed by the perception of huge wins.   So greed would ensure a steady stream of new suckers to the game.  Moreover, both emotions could be extremely useful in bamboozling players to make the wrong decisions, to hand over their hard earned money in the form of losses to the fortunate winners of the game. To spice things up a bit a few entertainers, such as clowns, magicians, charlatans and glamour beauties could be hired to further seduce the players, make them even more bewildered, but keep them eager and playing.

This game isn’t fiction, it actually exists and probably if it were masterminded by America’s best known gangster, Al Capone, he would have been arrested by the authorities and charged for running a racket.  But that is not going to happen because this game is played by those respectable, eloquent, suited and booted men and rubber stamped by our own political masters.

So the stock market, like in the game mentioned above, is driven by similar emotions, fear and greed. Emotional investing/trading is akin to holding a match to a stick of gelignite. The results can be equally damaging to you and your wealth. 

So those who invest using their logical analytical side of their brain, rather than their emotions tend to perform better than their rivals. These types of alpha investors are different to the rest, in a sense that they tend to have a well thought-out plan by their side, ready to implement should things go pare shaped.  By doing this, somehow they have managed to suppress the primitive side of their brain, which controls the emotion of fear.  

Somehow, and perhaps this is due to the forces of natural evolution, way back when homosapians lived in caves and carried clubs they had to react fast, for survival reasons, to the sounds of a roaring lion. So modern humans are hardwired to respond to negative event, which tend to spark off stronger emotional behavior and a cognitive response, than positive event. Perhaps this explains why sharp falls on the market are often steeper, rapid and more violent, than rises. Indeed, that shear blind panic, as people are desperate to avoid losses can be devastating, resulting in a stock market crash.  

Nevertheless, if investors over react to bad events and oversell the market due to their irrational fear this could also offer a buying opportunity for cool headed bargain hunters.  Again another strong emotion, greed would draw the bulls in.  

Keep an eye on the FTSE big losers of the day and track their share price the following day, notice how the big losers yesterday sometimes are the big winners the following day.

But over optimism can equally be detrimental to investors’ decision making, as can excessive pessimism.  Are we now witnessing over optimistic investment in parts of the technology sector today with some companies exhibiting colossal PE ratios with titanic market capitalizations.  Have you heard the expression a “suckers rally?”  Fair enough, keep dancing while the music plays, nobody likes a party-pooper but make sure you’re near the exit door when the bulls make a dash for it.

On the other hand, investors with well thought-out investment plans, which clearly outlines what they should do if the financial markets move against them. Who offset potential losses that they may occur from other investments in their portfolio, an investment strategy known as hedging; tend not to panic in a market crash because they have already factored in their tolerance to risk. Moreover, by not acting on their emotions they tend to make better investment decisions and outperform their competitors. They are able to see buying opportunities in an oversold market and profit from the fear of others. They are also able to avoid buying bubbles. Indeed, these alpha investors profit from the erratic mood swings of the market.   

So the cost of emotional investing to an investor is huge, moreover it fuels the profits of the others who act with their head rather than their emotions. By having a plan in place you won’t be like a startled, rabbit staring frozen at the headlights when the market moves against your investments.