Exchange Traded Funds | EFT

The Uses of Exchange Traded Funds (EFT)

Exchange Traded Funds (EFT) - Pros and Cons

There are many types of investments available these days. From stocks to bonds to mutual funds, financial opportunities abound, so how do you choose the one that’s right for you?

Exchange Traded Funds (ETFs) are just one type of investment vehicle that you can select, but before you jump in make sure you know the pros and the cons.

What are Exchange Traded Funds?

Exchange Traded Funds (ETFs) are funds that pool moneys for targeted investment purposes. Introduced in the United States in 1993, ETFs combine mutual fund and stock share trading into a single investment product.

They allow you to be financially involved in the growth of a particular industry or segment (such as energy) and are traded on an exchange.

ETF performance is dependent on the performance of the shares it holds which, ideally, will closely follow the performance of the index the fund is mimicking,.

According to the U.S. Securities and Exchange Commission, “Exchange-traded funds, or ETFs, are investment companies that are legally classified as open-end companies or Unit Investment Trusts (UITs), but that differ from traditional open-end (mutual fund) companies and UITs.”

EFT's are set up to mimic certain stock market indices such as the S&P 500, the Nasdaq or the Dow. Moreover, there are literally hundreds of EFT's tracking all sorts of baskets of stocks, like gold shares, oil shares and foreign traded stocks, just to name a few.

You can also trade in EFT's that follow bond indices.

Whatever your investment goals, there should be an Exchange Traded Fund to meet them.

Benefits of EFT's

There are several major benefits to trading in EFT's.

Like an open or closed end mutual fund you have diversification across different stocks in a given industry. This lessens risks somewhat.

You, of course, choose the industry and, in many cases, you can concentrate your investment more directly in a certain sector than you might be able to with a mutual fund.

Because EFT's are meant to mimic indices, they entail lower management and trading costs. Also because they are bought and sold like stocks, you can get in and out of them for as little as $7.00 a trade, if you use a discount broker.

No-load mutual funds carry no trading costs - they do however carry management fees that, for a good fund, are in the area of 1%.

However many mutual funds will charge redemption fees if you don't stay in the fund for a certain period - sometimes as long as six months.

There are absolutely no restrictions on buying and selling EFT's. They can be day traded if you wish.

Another major advantage of an EFT over a mutual fund is that it is continuously priced throughout the day and can be traded whenever the markets are open. Traditional mutual funds are priced at the market close each day and purchases and sales are only settled at that time.

Open end funds are traded like EFT's, however most have had a dismal long term track record and many have their shares selling at a discount to asset value, something that should not happen with an EFT.

Finally there is the down-tick rule. When the Dow is down more than 170 points, you cannot short a stock until there is at least one trade to the upside. This is meant to prevent a rout.

EFT's have been exempt from this rule, so it can be used as a short selling vehicle on down days.

Drawbacks

There are few drawbacks to EFT's.

You don't get professional management of your money - you're just mimicking an index.

For that reason, many experts do not advise the use of EFT's for long term investments.

If you don't know what you're doing, you may be swayed to jump in and out of these vehicles at the wrong time. But this is not a problem limited to EFT's and if you don't know what you're doing, you shouldn't be trading them.

There is no opportunity to buy without a brokerage commission, but I think this is offset by the low management fees.

Finally, the major risk associated with sector investing is that you pick the wrong sector. Diversification across a sector doesn't cushion you from loss if the sector is in a free-fall.

A better long term strategy is to invest across sectors, with the hope that some sectors will hold their own or even rise while the rest of the market is falling.

All in all, exchanged traded funds are useful investment tools, especially for short term use of your money.

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