What is an ETF?

According to the Investment News, the exchange traded fund (ETF) market passed a key milestone in 2011 when the total assets invested in ETFs crossed the $1 trillion mark. Despite their growing popularity, many investors are still not sure exactly what ETFs are. As with any investment, it pays to be an educated investor.

An ETF is a basket of investments such as stocks, bonds, commodities, currencies, options, swaps, futures contracts or other derivative instruments that tracks the performance of an underlying index or sector. Like a mutual fund, an ETF pools investors' assets and is managed by a professional fund manager who invests the fund's assets according to a specified strategy.

However, not all ETFs are created equal. Some traditional ETFs may be appropriate for long-term holders, but others, such as synthetic leveraged and inverse ETFs, are complex, come with additional risk, and may require daily monitoring.

Traditional ETFs

According to some investment professionals, traditional, fixed-income ETFs may effectively be used to balance a portfolio of mutual funds and individual bonds.

A fixed-income ETF is a special type of mutual fund designed to track the performance of a specific bond market index. Unlike bonds that generally pay interest semi-annually, fixed income ETFs usually distribute monthly dividends. In addition, most ETFs have no maturity date. The bonds in a fixed income ETF will mature eventually, but the proceeds are reinvested in new bonds rather than returned to investors. Fixed income ETFs are traded on the securities exchange and can be traded just as any listed stock. Also unlike bonds, an ETF's trading history and price quotes are readily available.

Some additional reasons why it may pay to add fixed-income ETFs to a bond portfolio:

Maintaining Market Exposure: Investment grade and municipal bonds are thinly traded. As such, the right fixed income product may not be readily available. Cash can be put into a fixed-income ETF to maintain exposure to the bond market, and then easily be liquidated once an appropriate bond is found to purchase.
Diversification: Bonds trade in larger lot sizes than stocks so it is more difficult to build a diversified bond portfolio. Fixed-income ETFs are diversified by nature.
Liquidity: Individual bonds can be a good source of income, but they are not very liquid. Fixed-income ETFs, on the other-hand, are very liquid, allowing investors to quickly adjust their portfolio exposure to take advantage of new opportunities.
Management fees: Although trading ETFs may result in brokerage commissions, fixed-income ETFs tend to have significantly lower management fees and are more cost effective to trade than individual bonds.
Synthetic ETFs

Synthetic ETFs, such as leveraged and inverse ETFs explained below, are generally not appropriate for "buy and hold" investors. An ETF may reset each day, and if held longer than one day, its performance may quickly deviate from the underlying index it is attempting to mirror.

Leveraged ETFs use financial derivatives and debt to multiply the returns of an underlying index. Leveraged ETFs aim to keep a constant amount of leverage during the investment period, such as a 2:1 or 3:1 ratio. For example, for a leveraged ETF with a 2:1 ratio, if the underlying index returns 1%, the fund will theoretically return 2%. The ratio impacts the losses in a similar fashion, a drop of 1% in the index would result in a 2% loss in the ETF. Leveraged ETFs are often marketed as a way for investors to hedge their exposure to downward moving markets.

Inverse ETFs, also called "short" funds, use various financial derivatives to profit from a decline in the value of an underlying index. Investing in an inverse ETF is similar to holding various short positions in order to profit from falling prices. An inverse ETF that tracks a particular index seeks to deliver the inverse of the performance of that index.

Leveraged inverse ETFs, also called "ultra short" funds, seek to deliver a return that is a multiple of the inverse performance of the underlying index. For example, a 2:1 leveraged inverse ETF that tracks a particular index seeks to deliver double the inverse of that index's performance.

Most leveraged and inverse ETFs are designed to achieve their stated objectives on a daily basis. As such, they are not meant to be held for longer periods of time - weeks, months or years. If held for more than one day, their performance can differ significantly from their stated performance objectives.

In addition, leveraged and inverse ETFs may be less tax efficient than traditional ETFs due to daily resets requiring more frequent trading. Frequent trading could possibly result in short-term capital gains that may not be offset by a loss. On the other hand, traditional ETFs may provide greater tax efficiency through fewer capital gains distributions.

Because ETFs are traded like stocks, each purchase and sale may result in the assessment of a brokerage fee or commission, usually on a per transaction basis. Since leveraged and inverse ETFs are traded more frequently due to their volatility, an investor could easily incur substantial brokerage fees and commissions.

As with any investment, investors should consult an investment professional and tax adviser for a full explanation of an ETF's risks, benefits and potential tax consequences before adding it to their portfolio.

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