A Quick Look at Exchange Traded Funds

By Ken Long

An exciting new class of trading vehicles is starting to emerge all over the world equity markets: Exchange Traded Funds (ETFs).

They are typically low cost, index-tracking funds that trade like a stock.  These baskets of securities can be bought or sold throughout the market day and offer exposure to leading indexes, sectors and even individual countries throughout the world.  Many can even be shorted on a downtick, an advantage that means a lot to short-term traders hoping to capitalize on intraday volatility to the downside.

The American Stock Exchange, for example, a world leader in the development marketing and trading of ETFs, lists more than 120 funds with assets in excess of $150 billion USD.

ETFs have advantages over mutual funds that include:

• Portfolio transparency-- you can see what they hold

• Low turnover rates--leads to more cost effective administration and tax efficiency

• No minimum investment level (in most cases)

• Continuous intraday pricing

•  No limits on trading frequency

•  Optionable

ETFs also have advantages when compared to individual stocks, such as:

• Diversification at lower cost

• Smoother equity curve and less volatility (not in all cases!)

ETFs are not without their disadvantages, as you would expect.  Depending on your investing or trading style, there are issues of liquidity, volatility, size, tax consequences of buying and selling, as well as dividend and capital gains distributions, and administrative costs to consider before jumping on the bandwagon.  Do not discount the cost of trading in your calculations!

ETF strategies come in many flavors.  To list just a few:

• A low cost way to implement a low maintenance asset allocation strategy

• To efficiently manage a market timing strategy

• To reduce, company-specific risk

• As a portfolio hedge

• As part of a tax-selling strategy or to improve tax efficiency

• As a means to add diversity to an overly focused portfolio

• A way to achieve specific sector or index exposure in an efficient manner

• To achieve market exposure more efficiently than with mutual funds

• To improve the task of portfolio management

• To efficiently trade macro opportunities

• To efficiently trade the reaction to unexpected news events

• To take advantage of short-side trading

ETFs are certainly not the be-all-and-end-all of trading vehicles, but for the informed investor they add a very useful set of tools to your toolbox.

As an example, a new way to participate in the often perilous gold market appeared last week, with the announcement of GLD, the ticker for streetTRACKS Gold Shares, which began trading on the NYSE on Thursday, November 18, 2004.  GLD happens to be a tricky way to play a tricky market, since this gold-bullion based Exchange Traded Fund (ETF), tracks the actual commodity, the first US ETF to do so.  GLD is sponsored by the World Gold Council and marketed by State Street Global Advisors.  Each share will initially represent one tenth of an ounce of gold bullion as priced by the London Bullion Market Association.  This will diminish over time, as the fund will pay expenses by selling gold held in the trust as needed.  The initial expense ratio is pegged at 0.4% per year. Initial trading in the ETF has been brisk, with over 17 million shares changing hands in the first 2 days of trading.

Barclays Global Investors, the world’s largest provider of ETFs, recently filed a final version of its registration statement with the SEC for its own gold ETF, which will trade on the AMEX under ticker IAU.

The Dow Jones newswire notes that shareholders' gains will be taxed as if they own the underlying gold, which translates into a higher rate. Under current law, gains on the sale of "collectibles," including gold bullion, held for more than one year are taxed at a maximum rate of 28%, rather than the 15% rate applicable to most other long-term capital gains.

GLD and IAU are just one type of ETF available to individual investors.  ETFs are growing in popularity and offer a number of advantages to individual investors regardless of style.  They can be used in creative ways whether your strategy calls for leisurely asset allocation, position trading, swing trading, intraday trading and scalping, or whether you simply are looking for a more efficient way to capture the returns of specific segments of the world equity markets. With over 120 ETFs offered in the US, you can find ETFs that track broad markets, defined market sectors, individual countries, or narrowly focused industry sectors.

Learn about the Van Tharp Institute Course On ETF's

Ken Long, a retired Lieutenant Colonel in the U.S. Army with a Masters Degree in System Development, is currently a professor of tactics and logistics at the Army's Command and General Staff College. He has developed the Tortoise Method of mutual fund switching, a trading system which takes about five minutes each week with a goal of outperforming the S&P 500 Index. 

Ken is the featured speaker at the Van Tharp Institute's brand new course on Trading Exchange Traded Funds, coming in February 2005. Ken is also speaker at Dr. Tharp's upcoming Infinite Wealth Course. 

He is a trader, writes a daily and weekly market assessment for mutual funds and exchange traded funds. He is a proud husband, dad, and a ju jitsu practitioner. 

To learn more about his Tortoise method visit and sign up for a 30 day guest account, visit www.tortoisecapital.com or contact him at ken@tortoisecapital.com