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Advantage: ETFs: investment benefits of exchange traded funds.

The investment community is perennially abuzz with innovative products and services. And while many eventually fade, exchange traded funds (ETFs) have thrived thanks to beneficial tax and diversification characteristics. As these attributes accrue to the advantage of their clients through widespread ownership of ETFs, tax professionals can profit from an understanding of the features of these securities.

ETFs afford a convenient gateway to the most aggressive investment instruments (think emerging foreign equity markets and commodities) and the most conservative, such as Treasury Bills. Like conventional mutual funds, dividends and income are distributed to investors on a monthly, quarterly or annual basis.

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Perhaps the best way to understand the utility of ETFs is to review the advantages they offer to investors namely diversification, reduced expenses, trading flexibility, transparency and tax efficiency.

Diversification

Firms underwriting ETFs have introduced a dazzling array of investment offerings since the 1993 introduction of the first ETF. Standard and Poor's Depository Receipts. ETFs may represent the equity markets of individual countries (Italy, Brazil) or regions (Latin America, Europe); industry sectors (Financials, health care, semiconductors); or size and style designations (Russell 2000 Small Cap Growth stocks). Recent innovations have provided access to fixed income instruments (Aggregate Bond Index, Treasury Inflationprotected Securities), commodities (gold, petroleum) and REITs.

Most ETFs afford diversification within a classification, holding a range of individual securities within the specific category. Each ETF represents an immediately diversified sampling within the defined class. An intelligent selection of ETFs permits an extraordinarily diversified portfolio of stocks, corporate and government bonds, commodities, etc. This broad diversity and the specific focus of each security permit asset allocations to match almost any client profile.

Nonetheless, it's important to understand that portfolio construction for every individual investor still requires diligence and deliberation. ETFs in one narrow sector would provide little expected mitigation in volatility. Careful evaluation of each security' and issuer is key.

Reduced Expenses

ETFs are frequently passively managed collections of securities, with low turnover. Consequently, the management fees are generally quite low. However, fees can vary as a result of operating costs associated with various markets.

Trading Flexibility

Open-end mutual funds, which are more familiar to investors, are purchased and redeemed through mutual fund companies. The cost per share or redemption value of a fund depends upon the net asset value of the shares (the cumulative value of the securities held by the fund) at the close of business on the day a transaction is consummated. Open-end fund transactions settle after trading hours. ETFs are bought and sold throughout the trading day, however, just like individual stocks. Traders may thus lake advantage of intra-day market conditions.

Because ETF units may be created or redeemed throughout business hours, arbitrageurs are constantly watching for disparities in their pricing, relative to the net asset value of the securities held in each ETE The ability of authorized participants (primarily large brokerage and arbitrage securities firms that are allowed to exchange baskets of individual, specified constituent securities for ETFs) to create and redeem shares acts to mitigate the variations between market price and underlying values.

As a result of these market forces, the '"tracking error" (the differential between the price and the net asset value of a given ETF) is generally low. In other words, the prices at which ETFs trade closely track the underlying values of the securities they hold within.

In addition to the ease of acquiring ETFs at market conditions and the lack of large premiums or discounts to net asset value. ETFs offer other trading options unavailable with open-end mutual funds.

Traders may institute limit orders at specific prices, stop-loss orders to guard against unexpected market turmoil and short sales in anticipation of market declines.

Transparency

Transparency has assumed unprecedented significance in this age of increasing economic uncertainty. The holdings of many ETFs arc: defined by familiar market indices. The constituent securities held, and their respective weightings, are published in prospectus form and arc usually available online. Investors may generally determine at any time what they own in their positions. Asset allocation can be set with a high degree of precision.

Tax Efficiency

Turnover in the holdings of a mutual fund may result in gains or losses on the sale of individual securities within the fund. Mutual funds are required to distribute excess capital gains to shareholders each year. As a result, investors may receive fund distributions, even though they might prefer not to realize any gain. As a result of the tax treatment of the in-kind transfer process utilized in the creation of ETF units, many ETFs rarely make capital gains distributions. Investors may therefore exercise much more control over the realization of taxable capital gains when holding ETFs than with traditional mutual funds.

There are Constraints

Notwithstanding these advantages, ETFs do have constraints relative to traditional funds. Active management in an open-end fund may enable a savvy portfolio manager to avoid major market dislocations through prescient trading actions. ETFs generally do not attempt to out-smart the markets, so investors assume responsibility for allocations. In addition, the purchase and sale of ETFs by investors generally involve trading fees or commissions.

Despite the design of many new ETF classes in recent years, not every sector of every market is represented. And while most traditional funds permit automatic reinvestment of dividends and capital gains, ETFs generally do not. Thus, an investor wishing to remain fully invested must pay attention to payments received in the account.

Still. ETFs oiler several positive features for investors and may be utilized in conjunction with other securities to provide a well-rounded investment program.

wantmore?

Check out CalCPA's investment news, as well as retirememt and financial planning resources--including information on CalCPA's Personal Financial Planning Committee--at www.calcpa.org/RIFPresources.

Barry L. Pinsky, CFP is a vice president of investments at UBS Financial Services. You can reach him at barry.pinsky@ubs.com.
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Title Annotation:financialplanning
Author:Pinsky, Barry L.
Publication:California CPA
Date:Jan 1, 2011
Words:976
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