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Exchange Traded Funds or ETFs are relatively new investment vehicles that are helping to make Portfolio Managers and novice traders alike more dynamic and potent investors. ETFs can be defined as index-based products, in that each ETF holds a portfolio of securities that is intended to provide investment results that, before fees and expenses, generally correspond to the price and yield performance of the underlying benchmark index. In other words, ETFs give an investor a diversified basket of securities packaged into one easily tradable security. And, unlike mutual funds, which are also generally diversified, ETFs can be traded frequently throughout the open hours of the market.
ETFs are being created in widely varied forms and increasingly specialized formats. The earliest created ETFs tracked an index like the S&P 500 or a sector within the S&P 500 Index like Information Technology. The next wave of ETFs tracked stock indexes based on market capitalization and the indexes of international markets. And the most recent ETFs are more complex, such as a recent group of ETFs that are fundamentally weighted according to a stock’s dividend yield or earnings yield and ETFs that track commodity indexes and natural resource indexes. And for more complicated trading strategies, a series of ETFs have been created that add leverage to the equation, allowing investors to get double the performance or inverse performance of an index. For example, an ETF exists that doubles the inverse performance of the Dow Jones Industrial Index; if the Dow falls 5%, the ETF will return a positive 10%. With this expanding arsenal of ETFs, investors can easily utilize strategies that were previously difficult to execute.
Probably the most beneficial use of ETFs for the average investor is easy diversification. Diversification is the foundation of risk management and is realized by building a portfolio that consists of unrelated or uncorrelated assets. The assumption behind this theory is that not all assets behave in the same manner or react in the same way to the same events; thus a combination of uncorrelated assets will reduce the volatility of the portfolio. Before ETFs, in order to diversify a portfolio an investor had to buy numerous individual stocks, bonds, commodities, real estate assets, etc. Or an investor had to rely on mutual funds, the universe of which is difficult to navigate and composed of funds that generally charge higher fees and are less tax efficient than the average ETF. Furthermore, an investor had to be sure that the managers performed well and actually executed the strategy they described in the prospectus. However, a portfolio of just a handful of ETFs could give you exposure to several asset classes and hundreds of individual securities.
ETFs are also very useful for developing esoteric trading strategies once reserved only for hedge funds and other large institutional investors. For example, ETFs make it possible for anyone to short the market, i.e. bet on the market going down. They also make it possible to make huge, fast sector trades with the purchase of a single security. Prior to ETFs, such a move would require purchasing multiple stocks, which would generate large trading fees, or buying a sector mutual fund, which cannot be traded more than once a day and may draw penalties for quick entry and exit. ETFs also make it easy for an investor to buy and sell commodities and natural resources that were previously inaccessible to most investors. Even currencies are no longer out of reach. If one believes that the Euro is going to outperform the U.S. Dollar, there exists an ETF that will allow him to capitalize on that assumption.
The Exchange Traded Fund is undoubtedly one of the most revolutionary financial products of our time. ETFs alone or, in combination with other securities, offer an infinite number of trading and investing strategies. Furthermore, they are invaluable risk management tools for large and small investors alike. And because of the variety of ETFs available and their versatility and ease of use, all investors can now implement practical investment strategies that can be as simple or elaborate as any investor desires.
Source: Yahoo Finance
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