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Are you afraid of ‘spiders’?
No, I’m not talking about those hairy, eight-legged
creatures. I’m talking about Exchange-Traded Funds (ETFs).
It is important you understand this investment vehicle
because they offer several advantages over mutual funds.
Read on to find out how ‘spiders’ and other Exchange-Traded
Funds can be a valuable part of your portfolio.
Any time you invest in the stock market you want to make
sure you minimize your risk through diversification. That
can be difficult to do using individual stocks. That’s why
so many people and advisors turn to mutual funds. A mutual
fund allows an investor to easily diversify because every
dollar you invest is divided among many underlying
investments. For instance, a mutual fund that is designed to
mimic the S&P 500 Index would own the same 500 stocks that
make up the index in the same proportion as the index.
Exchange-Traded Funds provide the diversification benefits
of a mutual fund with the advantage of being traded like an
individual stock. Whereas a mutual fund can only be bought
or sold based on that day’s closing price, Exchange-Traded
Funds can be bought or sold anytime throughout the trading
day. This gives you greater flexibility.
Exchange-Traded Funds are designed to mirror a market index.
There is an ETF for practically every index available. The
three most popular stock market indices are the Dow Jones
Industrial Average, the S&P 500 and the NASDAQ. The ETFs
that mirror these indices are referred to as Diamonds,
Spiders and Cubes because their symbols are DIA, SPY and QQQ.
Exchange-Traded Funds can be used in all areas of a
portfolio. Many are available that invest in the stock of
large, medium or small companies both in the U.S and
internationally. And Exchange-Traded Funds aren’t just for
stock-based investments. There are separate ETFs that invest
in bonds, real estate, precious metals and other
commodities. There are ETFs designed for growth and others
designed for income.
Exchange-Traded Funds are not actively managed like some
mutual funds. For instance, actively-managed mutual funds
try to out-perform a market index by only owning some of the
investments that make up that index. Many also have the
ability to increase the amount the have in cash during
declining markets. When using Exchange-Traded Funds, these
decisions are up to the individual investor and/or their
advisor.
This decision making flexibility means that Exchange-Traded
Funds offer tax advantages not available in a mutual fund.
As people take their money out of a mutual fund, it can
force the manager to sell investments that would otherwise
be held. Each time a mutual fund manager sells an underlying
investment, it generates a capital gain or loss for the
mutual fund investor.
So even though the investor may own the fund for several
years, they must pay taxes based on the decisions of the
mutual fund manager each year. Particularly frustrating to
mutual fund investor’s is having to pay taxes on a fund in a
year that it has declined in value! If the same investor
owned an ETF, he/she would be able to control the timing of
the sale and the resulting taxes in order to minimize their
effect.
The internal expenses of most Exchange-Traded Funds are very
low. The average actively-managed mutual fund may have
internal expenses over 1% per year. The internal expenses of
Diamonds, Spiders and Cubes are less than 1/5 of 1% per
year. (Since ETFs are purchased like a stock, there is a
commission to buy and sell them. The use of a discount
broker should minimize this expense.)
For many of my clients, about 50% of their portfolios are
made up of Exchange-Traded Funds because they give us the
ability to quickly respond to unpleasant market events. If
you are concerned about the impact a terrorist event can
have on the value of your portfolio then you may want to
consider ETFs for a portion of your money.
So don’t be afraid of ‘Spiders’ and consider adding
Exchange-Traded Funds to your portfolio. They can lower your
costs, increase your flexibility and give you greater
control over taxable events while still participating in the
potential growth of the market.
For clear, straightforward, unbiased answers, submit your
questions to www.guardingyourwealth.com/askjeff.htm.
Mr. Voudrie is a Certified Financial Planner, nationally
syndicated newspaper columnist and President of Legacy
Planning Group, Inc., a Private Wealth Management Firm in
Johnson City, TN. He can be reached toll-free at
1-877-827-1463 or
www.guardingyourwealth.com.
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