Investing in ETFs
Over the last several years, ETFs (Exchange Traded Funds) have emerged as a very serious alternative to the mutual fund. Investing in an ETF offers many of the advantages that mutual fund offers, such as a diversified basket of assets that closely track a market index. The ETF and the mutual fund are also similar in that the underlying shares represent ownership in the basket of securities held by the fund. There is a very big difference between the 2 in that the ETF is traded within a stock exchange and is constantly valued based on the underlying securities, whereas the mutual fund is only revalued at the end of the trading day.
Shares of ETFs are created and redeemed by an Authorized Participants. These APs are typically institutional traders that are trying to make small profits on the arbitrage opportunities between the ETF values and the value of the underlying securities. The value of these securities are repriced every 15 seconds therefore allowing the ETF to be revalued throughout the day. The market activities (buying and selling) throughout the day keep the NAV (net asset value) of the ETF very close to the NAV of the underlying securities — but when these values diverge, the APs can profit. As for the individual investor, you are able to buy and sell these securities throughout the day, where trading in mutual funds are valued at the end of the day. On days where there is tremendous volatility (like lately), you can profit from broad moves in the index, or just buy and sell the index trends.
ETFs generally do not impose 12b-1 fees, so the expenses associated with ETFs are typically less than mutual funds. Other fees are typically lower since the ETF companies do not have to buy and sell the underlying securities, where mutual funds have to — this also lowers what you would know as the expense ratio.
The other advantage was mentioned above and that is that there is much trading flexibility with ETFs since they can be bought and sold on the exchange and intra-day prices. ETFs can be purchased on margin; they can be sold short and they can be sold with stop orders. A stop order allows an investor to specify the price that they are willing to buy and sell shares.
