ETF’s, Superman and Popularity Contests

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A lot of people don’t know what ETF’s are and sometimes it’s hard for them to wrap their minds around the concept.

For many of my ETF related posts, I often provide a link to a page that gives you a snapshot and a generic definition, but I’m not sure that’s enough.

So I want to go over a few key concepts when it comes to the mechanics behind ETF’s. Much of this will come from my personal experience with fielding ETF based questions.

There’s gonna be a good dash of fact thrown in, along with a good dash of opinion. I’d like to eliminate some of the confusion and misconception surrounding these suckers and put it out there in plain English.

In past articles, I’ve written about many of the core benefits of owning ETF’s. Right now, I’d like to take a step back and talk about what’s under the hood, the things that seem to trip many people up.

What’s in a name anyway

I think one of the main reasons some people struggle with the term ‘ETF’ is because of it’s nondescript name. You would have thought that they might have come up with something a little catchier, something that rolls off the tongue, something like DPTLAIP (Diversified Portfolio Trading Like An Individual Position).

The reality is that it’s hard to give it a sexier sounding name. ETF is exactly that, a Fund that Trades on an Exchange or AFTTOAE. ETF’s trade on the NYSE, AMEX, ARCA, etc. I think we’re stuck with the acronym ETF until something more appealing comes along.

A win win situation

ETF’s have the characteristics (mainly diversification) normally associated with mutual funds, at the same time they trade like stocks do intraday. Superman and Clark Kent all rolled into one.

On the surface, ETF’s look like stocks and that’s how you should picture them in your mind. That’s what they will look like on your monthly statement. But don’t be fooled… just one, stock-like ETF position, can give you the diversification of a mutual fund, instantly.

Stork-like Entrance

Normally a stock is born through an IPO or Initial Public Offering. Usually, a group of investment banks get together and issue a set number of shares to the public. This process can take months, sometimes years. ETF’s are not born this way.

ETF shares can be created on demand by Authorized Participants such as institutional trading desks, specialists and other approved market makers. They are released directly into the secondary market (the everyday market that you see on CNBC, etc.) at a price equal to the cost of purchasing the basket of securities that make up the index the ETF is tracking.

Clear as water

ETF’s are completely transparent. They’re required to disclose their holdings on a daily basis. For example, if you own the ETF (DIA) then you own the 30 stocks that make up the (DJIA) Dow Jones Industrial Average. Plain and simple.

With other investments you have no where near that kind of transparency. As an investor you should know where your money is being invested, and with ETF’s you always do.

Popularity contest

The 3 most actively traded US equities are ETF’s, and 5 of the 10 most actively traded US equities are ETF’s. More and more investors (and advisors) are pouring their money into ETF’s on a daily basis. Although, some advisors are scared to move clients into ETF based portfolios, for fear of losing their grip.

Dividends

ETF investors are entitled to the dividends of the underlying companies that make up the basket of stocks or bonds of the underlying index. For instance, the DIA pays a monthly dividend, passing on the dividend income (to investors) from the underlying companies that make up the DJIA.

In conclusion

Today, it’s very possible to use ETF’s to build your entire investment portfolio. In fact, it’s something I think would make a lot of sense for many people. I wrote more on the subject in breaking down your investment options.

In my next post I’ll look at an ETF based model portfolio. Get ready, the gloves are coming off…

Tags: ETF, ETF authorized participants, Exchange Traded Funds