Investing can be a lot of fun but it can also be (and should be!) a lot of work. My team at FEG spends countless hours poring over balance sheets, charts, and economic data to make sure our clients have the best investments for the appropriate amount of risk. However individual stocks aren’t the only game in town. Most people, when they think about investing, turn their attention to stocks, bonds, and mutual funds. What often isn’t discussed are Exchange traded funds (ETF), which provide investors with more options for their portfolio than many investors realize.
These investment vehicles trade throughout the day like stocks but have a basket of holdings similar to a mutual fund. An ETF can be viewed as a specialist while a mutual fund is more like a general practitioner. A specialist is often times an expert in a single field of medicine, whether it is the heart, brain, or bones. Each ETF has a specialty; an exchange traded fund that tracks a technology index should not be expected to one day start investing in grocery stores or oil companies.
Another difference between ETFs and mutual funds are the tax implications. Each year mutual fund companies must pass on a set percentage of that year’s capital gains to shareholders. If a stock that had been a holding within a mutual fund is sold, then the recognized capital gains from that sale are passed down to the current shareholders at the end of the year, no matter how long they have owned the fund. While ETFs are considered more tax efficient, acting like stocks, in that any capital gains are not recognized until the ETF itself is sold, this allows the investor more control over their own personal taxes.
Investors need options. Many don’t want to be pigeon-holed into just being able to allocate their assets to a handful of general go anywhere, invest in anything funds. This is one of the reasons for the increase in popularity of ETFs. However not all exchange traded funds are created equal, investors still need to be weary of the cost of owning various funds, as many ETFs track the same indices while having varying expenses.
The ugly cousin of the exchange traded fund is the exchange traded note (ETN). Although they have similar names, they are created in nearly a completely different fashion. An ETN is an investment based on a promise; unlike ETFs they do not buy or hold the underlying assets to replicate an index. According to a FINRA press release on the risks of ETNs, there is a possibility the issuer of the exchange traded note defaults, which could have an obviously significant impact on the note’s price. While ETFs have their own risks, they aren’t as harsh as many associated with ETNs.
Like all investments, there are some inherent risks that must be considered and weighed. Asking these questions and examining the perils that we are exposed to comes with the territory of allocating capital. Some are more critical than others, but being aware of them is important.
Joseph “Big Joe” Clark, whose column is published Sundays, is a certified financial planner. He can be reached at bigjoe@yourlifeafterwork.com or 640-1524.
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"Big Joe" Clark
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March 16, 2013
'Big Joe' Clark: Investors have more options than they may know
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