How to Trade ETFs

Etf Cash Trading System

The Etf Trading System is the single most amazingly simple trading system that you've ever come across. Etfs are sort of a new trading vehicle. Etfs are electronically traded funds that represent underlying securities or commodities or indexes. There are thousands of different Etfs available today. They are very popular with big investors. If you can get a stock trading account, you can easily follow the Etf trading system! If you have an option enabled stock trading account, you can follow the Etf Trading System get even better results. We discuss how this works in the advanced section of the system.

Etf Cash Trading System Summary

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Portfolio Management Using ETFs

Chapter 18 provides tools and directions when developing a mix of ETFs based on our journey through life. A person who has just entered the workforce typically invests differently from one who is retiring from the workforce. Life cycle investing directs more weight to aggressive asset classes early in life and more weight to conservative asset classes later in life. Chapter 20 focuses special uses for ETFs in portfolio management. Those uses may include hedging a specific risk in a portfolio, such as a concentrated position in one industry. Pairs trading invests long and short in sectors or styles simultaneously in an attempt to capture cycles in the economy. A market neutral strategy invests either a long or short position in an industry, and invests the opposite way with a market index. Tax swapping is a conservative strategy for boosting after-tax returns.

The Nuts and Bolts of ETFs

n ETF is bought and sold like a company stock during the day when the stock exchanges are open. Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of ETF companies to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying security values. The arbitrage mechanism ensures that the price investors pay for ETF shares is close to the true net asset value (NAV) of the underlying securities that make up the fund. Chapter 2 covers the operations and management behind ETFs, including important participants that make the ETF market efficient. It also covers the share creation and redemption process, the trading of ETF shares on exchanges, and the symbology used in the ETF industry. There is a lot of useful information packed into these pages.

Individual Investors and ETF Trading

Buy and sell orders for ETF shares can be accomplished with a simple market order, or be conditional using limit orders, stop-loss orders, or many different types of orders that are used for trading common stock. ETFs can also be bought on margin and sold short. The Glossary of Terms explains each of these conditional trades. ETFs are not subject to the short-sale rules on common stock that require short sales to be executed on an uptick in price. A short sale occurs when an investor borrows stock and sells it on the exchange, hoping to buy it back at a lower price in the future. The SEC short-sale rule for common stocks was put in place to prevent short sellers from driving the price of a stock down by their trading activity. That does not apply to ETFs because short sellers cannot manipulate the price of an ETF. That is because ETF shares are based on an underlying basket of securities, and when ETF prices get out of line with those underlying securities, APs step in and drive ETF...

ETFsThe New Investment of Choice

ETFs are a very disruptive technology to the mutual fund world. The logical choice for mainstream investors was and continues to be ETFs exchange traded funds . Why Because these securities contained many positive attributes that conventional open-end mutual funds lacked including those that gave rise to many of the recent scandals. ETFs carry very low management fees commonly ranging from .10 percent to .40 percent versus 1.00 percent to 2.00 percent for many actively managed mutual funds. While some ETFs are more expensive, they tend to offer specialized investment options and ideas that are ETFs are linked to indexes that they are supposed to and generally do track. That makes them transparent and not so easily subject to manipulation. A wide variety of index-linked ETFs now exist that provide enough choice to achieve more than adequate diversification opportunities. Subsequent to the mutual fund scandal revelations of 2002-2003 ETFs became the most dominant preferred new...

What Took Etfs So Long To Catch On

Nate felt the ETF product best served the interests of the end user investor. Meanwhile, Jack Bogle remained dead-set against ETFs since he never believes in selling only buying. The fact that you can trade ETFs intraday gives investors the opportunity to hurt only themselves and their long-term performance, in his rather paternalistic opinion. But Bogle is now retired and his former firm Vanguard is now launching ETF products almost as quickly as other sponsors. And they're no doubt doing so since as Nate told me, ''That's where the money is.'' And due to the various mutual fund scandals fund sponsors are increasing their redemption fees for conventional mutual funds to limit or restrict investor trading of the shares. Doing this only increases the flow of money from more active or aware investors to ETFs.

The Negative Aspects of ETFs

The benefits ETFs offered to some investors are often disadvantages to other investors. Trading costs are one example. Depending where you trade, the cost to trade an ETF can be far more than the savings from management fees and tax efficiency. Trading flexibility is a second double-edged sword. The ability to trade anytime and as much as you want are a benefit to busy investors and active traders, but that flexibility can entice some people to trade too much. High turnover of a portfolio increases its cost and reduces returns.

Ultra Leveraged Short Or Long Etfs

If you want to add some beta volatility or spice to your index-based ETF portfolio, both ProShares and Rydex Investments have some ETFs for you. Both use strategies already employed within their conventional mutual fund products. These funds add double the performance of the index on either the up- or downside. Simply stated, this means you get more bang for your buck if you're on the right side of market trends. And if you're on the wrong side, well you lose twice the amount. Who wants these kinds of products Of course the issuers like them since the fees are much higher than for conventional unleveraged ETFs ranging over .75 percent per annum versus major index-based ETF fees of around .20 percent. Why are these so much higher These ETFs involve more management work and have a narrower, more limited, investment audience.

Actively Managed Etfs

Soon many actively managed mutual funds will be issued structured ''masquerading'' might be more apt as ETFs. Conventional mutual fund companies wish to participate in the ETF boom and see their market share being eroded by the new structure popularity. Aside from the obvious business intentions of the issuers, the benefits to having these ETFs for investors are still murky. One could well argue that in such a new structure fees could be lower. But are mutual funds ready to cannibalize their own existing products Is the ETF threat that great It must be so if they intend to proceed. Another benefit is being able to conduct transaction in these funds intraday versus waiting until the end-of-day NAV calculation. So in that sense it's a more efficient and flexible process. So actively managed ETFs defy the core ETF principal and should be avoided with one possible exception. As we shall see in later chapters, there's a possibility that a convergence between actively managed mutual funds...

The Advantages of Actively Managed ETFs

A few companies have been lobbying for actively managed ETFs in an attempt to make a name for themselves as product innovators and to ultimately license their methods to fund companies. That helps those companies become profitable, however little has been written about what benefits, if any, actively managed ETFs would have for individual investors. Here are several benefits. 1. The most talked-about benefit of actively managed ETFs is the opportunity to outperform indexes that other ETFs follow. Given the poor track record of most actively managed open-end mutual funds compared to index funds, it is hard to support that contention. Nonetheless, hope over reason is the way active management is marketed to the public, and from that perspective, I am sure actively managed ETF providers will be very successful at gathering assets. 2. The biggest benefit in actively managed ETFs will go to investors who would otherwise invest in a comparable actively managed open-end fund. An actively...

Disadvantages of Actively Managed ETFs

Fund companies will be required to disclose at least part of their holdings on a daily basis for actively managed ETFs to function properly. The authorized participants need a fund composition file each day that lists the securities to turn in for a creation unit. Finally, actively managed ETF managers may be reluctant to make adjustments in the portfolio for fear of front-runners and other traders in the marketplace. That reluctance could hurt ETF shareholders. All of these issues would reduce the competitive advantage of actively managed ETFs, and reduce investors' incentive to use actively managed ETFs over less-exposed traditional open-end mutual funds. 2. Actively managed ETFs may develop large premiums or discounts to NAV on volatile trading days. With index ETFs, authorized participants (APs) have been able to minimize the possibility of arbitrage by releasing or redeeming shares as a way of controlling inventory and, therefore, prices. Any time a price disparity becomes...

ETFs Organized as 40 Act Funds

ETFs created under the Investment Company Act of 1940 are divided into two types, Unit Investment Trusts (UITs) and Regulated Investment Companies (RIC). Both types of funds are not taxed directly. Rather, they are eligible to pass the taxes on capital gains, dividends, or interest payments on to individual investors. There are differences between the two structures, and of course differences in their offshoot structures. 40 Act Unit Investment Trusts (UITs). ETFs organized as UITs have several telltale characteristics. First, UITs are nonmanaged entities. Nonmanaged means the manager of the fund can have no discretion as to which securities go into a UIT and which do not. The manager must follow the index exactly. ETFs registered as investment companies can also participate in securities lending programs. The revenue generated by these activities may help the ETF offset expenses that otherwise could cause the performance of the ETF to lag behind the performance of its index (because...

Commodity Etfs DIRECT

In lieu of using a managed futures product such as the Rydex Managed Futures fund, there now exists commodity ETFs where investors can structure their own allocations and do so using whatever strategy suits them best. Leading the way in this regard has been Deutsche Bank DB , which has created a wide variety of commodity indexes upon which ETFs have been based. DB's products fall into several areas. First, there is the broad-based commodity index DBLCIX , which contains six specific commodity sectors crude oil 35 , heating oil 20 , gold 10 , aluminum 12.50 , wheat 11.50 , and corn 11.50 . The index is what ETF, DBC is linked to. Investors seeking to add commodities can utilize this ETF in whatever weighting they choose. Alternatively there is the more widely known index-linked ETFs based on the popular Goldman Sach's Commodity Index GSCI launched by Barclays GSG iShares GSCI . However, GSCI as of this date is weighted 71 percent to energy, which may be too heavily weighted toward that...

Broad US Equity and Style ETFs

Ihe ETF evolution has its roots in the broad U.S. equity market, and S& P indexes were the earliest benchmarks to be licensed. In December 1992, SuperTrust units were introduced. The exchange-traded units were benchmarked to the S& P 500 Index. One month later, the AMEX launched SPDR Trust (symbol SPY) and that ETF also tracked the S& P 500 Index. A couple of years later, the AMEX launched the Mid Cap SPDR Trust (symbol MDY) benchmarked to the S& P 400 Mid Cap index. Industry SPDRs made their debut in 1998 (see Chapter 12) followed by broad market style and size ETFs in 2000. All U.S. equity ETFs were benchmarked to S& P indexes. A series of ETFs based on custom index strategies was launched by newcomer PowerShares in 2003. The PowerShares Dynamic Market Portfolio (symbol PWC) seeks to replicate, before fees and After the successful launch of PowerShares ETFs, custom indexing became a new avenue for index providers and ETF companies to tap into the individual investor...

ETFs And Market Neutral Strategies

ETFs can be employed within the market neutral strategy since so many diverse sector issues exist to utilize. Some investors believe that being in the right sector is primary to achieving good performance. As we've discussed previously, given their diverse components indexes are inherently less risky than individual stocks. Many U.S. equity markets have ETF issues based on broad sectors, like the S& P 500 ETF SPY , commonly referred to as the SPYDR. And within SPY are subsector ETFs that break the index down with different issues. For example, the following is a list of SPYDR sector ETFs now both available and popular. It's important to remember that these ETFs are weighted, meaning the largest companies carry the heaviest weighting within each sector. For example, Microsoft would carry the heaviest weighting in XLK while smaller companies within the sector a lesser amount. Recently Rydex Investments launched an equally weighted version of the same SPYDR sectors that appeal to a...

Customized US Equity Index ETFs

This second portion of the chapter examines several customized U.S stock indexes including size and style strategies. A sampling of ETFs that follow customized U.S. indexes is provided at the end of the chapter. For a complete list of all U.S. ETFs, visitwww.theetfbook.com for a link to the www.etfguide.com ETF database. Index Strategy Box data can be screened and viewed in the ETF database.

How Do Etfs Work In Risk Management Applications

Existing ETFs are all based on benchmark indices. While there are important benchmarks and there are unimportant benchmarks, benchmark index derivatives are widely used in risk management applications. For example, an investor with an actively managed small-cap portfolio might feel that superior stock selection reflected in the portfolio will provide good, relative returns over the period ahead, but that most small-cap stocks might still perform poorly. The investor can hedge the portfolio's exposure to small-caps while capturing its stock selection advantage by hedging the small-cap risk with a short position in a financial instrument linked to the Russell 2000 small-cap benchmark index. Available risk management tools for this application range from futures contracts and equity swap agreements to the shares of a small-cap exchange-traded fund.

Sample List of Broad US Equity and Style ETFs

The following table is a sampling of ETFs that track broad U.S. equity indexes and style indexes. It is not a complete list because Table 10.1 Broad U.S. Equity ETFs, Including Size and Styles Market Index ETFs Broad U.S. Equity and Style Table 10.1 Broad U.S. Equity ETFs, Including Size and Styles Market Index ETFs Broad U.S. Equity and Style Average Fee Market Index ETFs Cusom Index ETFs Broad U.S. Equity and Style Average Fee Custom Index ETFs of the large numbers of funds that track U.S. equity markets. For a complete list of current ETFs, including the Index Strategy Box data, visitwww.theetfbook.com and www.etfguide.com. Table 10.1 is divided into two sections. The first section includes a sampling of ETFs that track market indexes, which are categorized as passive security selection and capitalization weighted. The second section includes a sampling of ETFs that track customized U.S. indexes. The average expense ratio of market index ETFs in the first section is only 0.21...

ADRs GDRs and Emerging Market ETFs

The system of trading international equities on U.S. exchanges allows the opportunity for ADR indexes. Enough ADR and GDRs have been issued so that they can be used to create emerging market indexes. Some of those indexes have been licensed and formed into emerging market ADR ETFs.

Global and International ETFs List

Global and international ETF investing is a rapidly expanding market. Table 11.1 is a partial list of ETFs that cover the international spectrum. The list includes ETFs that are benchmarked to markets as well as custom-made indexes. The list is a good starting point to finding an ETF that suits your needs. For a complete list of global, international, regional, and country ETFs, including the Index Strategy Box database, visitwww.theetfbook.com and www.etfguide.com. Table 11.1 is divided into three sections. The first section includes global, international, and regional ETFs that are benchmarked to market indexes. The second list includes single-country market index ETFs. The third is a list of global, international, regional, and country ETFs that track custom indexes. Table 11.1 Global, International, and Country ETFs_ Market Index ETFs Global, International, and Regional Table 11.1 Global, International, and Country ETFs_ Market Index ETFs Global, International, and Regional Median...

The Evolution of Industry ETFs

The first and still leading industry sector ETFs were launched in 1998. Select Sector SPDRs divide the S& P 500 into nine sectors. Many firms have followed State Street's success in the industry sector arena, and several have introduced global industry ETFs that track industry sectors around the world. Some ETF firms have launched products based on customized indexing strategies. The goal of those indexes is to outperform market industry indexes. PowerShares is the leader in the number of customized industry sector ETF products, including a series that follows quantitative methods and another that follows a fundamental weighting scheme. Other companies are not far behind, however. WisdomTree has dividend weighted industry indexes, Rydex and State Street now have equal weighted industry ETFs, and First Trust has launched the quantitative AlphaDEX series to compete head to head with PowerShares.

Partial List of Industry ETFs

Table 12.1 is a partial list of market and custom index industry ETFs, which will give you a sampling of the funds available. It is not a complete list because of space constraints, and several new industry ETFs are launched each year. For a complete list of industry ETFs, including Index Strategy Box data, visit www.theetfbook.com and www.etfguide.com. Additional information on industry ETFs can also be found at and from a variety of sources in the ETF Resource List found in Appendix B. Table 12.1 is divided into three sections. The first section includes ETFs that follow market indexes, the second list includes ETFs that follow custom indexes, and the third list includes REIT ETFs. Table 12.1 A Sampling of Industry ETFs Table 12.1 A Sampling of Industry ETFs Market Index ETFs Industry Sectors Fee Market Index ETFs Custom Index ETFs Industry Sectors Average Fee Custom Index ETFs REIT ETFs Average Fee REIT ETFs

Corporate Action ETFs

In an initial public offering (IPO) and at the same time two other companies are merging and another is going private in a buyout. The dynamics of corporate actions make for some interesting indexes and ETFs. In addition, corporate insiders are constantly buying and selling shares of their company's stock and exercising stock options before stock options expire. Their buying and selling activity is tracked by index providers who use it to create custom indexes that are the basis of ETFs.

Corporate Dynamics ETFs

ETFs that track indexes based on intangible measures like ''Most Innovation,'' ''Most Elite Workforces, ''Customer Loyalty Leaders,'' ''Most Productive,'' and ''Best Operating Companies.'' IndexIQbelieves that these attributes are too often overlooked in equity analysis, but represent many of the strongest drivers of corporate growth and equity returns. IndexIQ, Inc. and S& P will jointly manage IndexIQ indexes and BNYwill do the actual day-to-day management of the funds. IndexIQ Exchange-Traded Funds is a subsidiary of XShares Group, LLC, which is the same company that launched HealthShares ETFs in early 2007.

Leveraged and Short ETFs

The third category of special equity covers leveraged and short investing. Leveraged ETFs are designed to return twice the return of a market index price and a daily basis (not including dividends), albeit with twice the daily volatility of the index. Short (or inverse) ETFs are designed to return the inverse (opposite) of the market price return. Leveraged short ETFs return double the opposite of an index price return as measured daily. Daily price volatility affects annual returns. The more volatility a fund has over a period, the lower the long-term compounded return for the period. Since leveraged funds have twice the volatility of a nonleveraged fund, the expected long-term return is lower than double the price return, minus fees. The ProShares prospectus for the Ultra ProShares ETFs dated June 19, 2006, heeds this warning in its leveraged funds At the end of 2006, there were only a handful of leveraged ETFs and no inverse ETFs. One year later, there are 174 leveraged and inverse...

Special Equity ETFs List

Table 13.1 offers a partial list of Special Equity ETFs available on U.S. exchanges. There are many funds to choose from, and more are being introduced each week. The list is a good starting point to finding an ETF that might pique your interest. For a complete list of Special Equity ETFs, including the Index Strategy Box database, visit www.theetfbook.comandwww.etfguide.com. Table 13.1 is divided into three sections. The first section includes thematic ETFs the second list includes stock picker, sector rotation, and buy-write funds and the third list includes leveraged and short ETFs. All the funds in this chapter follow a custom index. Table 13.1 Special Equity ETFs Table 13.1 Special Equity ETFs Thematic ETFs Leveraged, Short, and Short Leveraged ETFs

ETFs Provide The Tools For Implementing Global Macro Longshort Strategies

I'm asked frequently by financial media reporters ''Are there too many ETFs '' My response is always the same ''No.'' Breaking down the answer further I tell them ''The more ETFs the better. What I think are needed issues don't necessarily agree with what Wall Street new product engineers and sponsors are issuing. But the more that are issued the more likely it is we'll find what we need, like a miner finds a gem in the rubble or tailings of his efforts.'' But as of this writing most of the ETFs we feel are needed have either been issued or are in registration to be released soon. Currency investing. Also confined previously to options and futures markets and or similar Managed Futures products. But now there exist a wide variety of currency ETFs whether for just the Dollar Index or individual currencies where investors at the retail level can use to hedge or speculate. Inverse ETF issues. Allow most tax-exempt accounts foundations, IRAs, 401(k)s and so forth for the first time to...

Socially Responsible ETFs

Investors in socially screened ETFs should be aware of what industries are being screened out of an index. You may not agree with what is being called socially irresponsible. For example, most indexes screen out weapons manufacturers and defense companies. As a retired U.S. Marine Corps officer, I have an objection to the providers of those indexes stating that companies in the business of protecting our families, our freedom, and our way of life are socially unacceptable.

Where To Put Your Indexed Investments Etfs Futures Or Index Mutual Funds

With the development of index futures and ETFs, investors have three major choices to match the performance of one of many stock indexes exchange-traded funds, index futures, and index mutual funds.9 The important characteristics of each type of investment are given in Table 15-1. As far as trading flexibility, ETFs and index futures far outshine mutual funds. ETFs and index futures can be bought or sold any time during the trading day and after hours on the Globex and other exchanges. In contrast, mutual funds can be bought or sold only at the market close, and the investor's order must often be in several hours earlier. ETFs and index futures can also be shorted to hedge one's portfolio or speculate on a market decline, which mutual funds cannot. And ETFs can be margined like any stock (with current Fed regulations at 50 percent), while index futures possess the highest degree of leverage, as investors can control stocks worth 20 or more times the value of cash. The trading...

Actively Managed Etfs And Mutual Fund Posers

Because of the popularity of the ETF structure there will be sponsors and even mutual fund companies issuing so-called ''actively managed'' ETFs. These types of ETFs basically defeat the indexing feature as there will be no index to link these to. What will no doubt occur is that firms and their new product engineers will develop strategies that they can market to the public through their in-house network Merrill Lynch, Smith Barney, Morgan Stanley and so forth of FAs or directly to the public through their impressive marketing operations.

The Future of Futures ETFs

ETF providers have just begun to issue new products benchmarked to new and interesting alternative asset class indexes. One key to development is an active derivatives market in the product the fund companies are trying to introduce. Where there is an active derivatives market, there can be successfully traded ETFs.

Unique Characteristics of ETFs

ETFs have unique characteristics that most open-end mutual funds do not have. These characteristics allow the creation of new and interesting trading strategies. ETFs can be leveraged or shorted, and many are paired with options. The following is a brief explanation of those characteristics. Leverage ETFs can be leveraged using margin. Margin is borrowing money from a brokerage firm to buy securities. Minimum account levels are required and enforced by the NASD, the NYSE, and by individual brokerage firms. Investing on margin can be profitable for investors if their profits from securities purchased overcome the interest charges and commission costs. Options While not an ETF per se, ETF options can give investors control over a large number of ETF shares with little money down. Albeit, options use substantial leverage and thus can mean substantially higher risks. There are two types of options call options and put options. A call option gives you the right to buy shares of ETFs at a...

Using ETFs to Reduce Industry Risk

One way to hedge a large position in a single company is to build a portfolio of industry ETFs around the position. Assume that you have 10 percent of your liquid net worth in one technology stock. You bought the stock years ago at a greatly reduced price and selling it would result in a large tax liability. Instead of selling the stock, build a portfolio of nontech industry ETFs around the position. The result is a portfolio that closely tracks the stock market while maintaining the single position. There are other ways to reduce industry risk exposure using ETFs. Instead of shorting an ETF, investors can buy an ETF that does the industry shorting for you. ProShares and Rydex have several inverse industry ETFs that short industry sectors. Another defensive approach is to use options on ETFs. Buying protective put options on ETFs in the industry would partially insure a portfolio against price declines in an industry. Finally, ETFs are being introduced that leave out industries. For...

Commodity And Currency Etfs

So enter ETFs based on both commodities and currency. This is exciting because it allows investors to conveniently add these issues to their portfolios without having to join expensive and complex CPOs or using any leverage. Now average investors can truly diversify their conventional portfolios using these products. Given the lack of leverage in the ETFs some of the benefits that Lintner noted may be lessened. But the emotional craziness often associated with futures and commodity trading has also been eliminated making it palatable for average investors. Some popular currency and commodity ETF products include

Defining ETFs

Exchange Traded Funds (ETFs) are baskets of securities that are traded, like individual stocks, through a brokerage firm on a stock exchange. Shares of ETFs are traded with other investors who are also going through brokerage firms to facilitate their transactions. All-day trading makes ETFs more flexible than their familiar sister open-end mutual funds, where investors must wait until the end of the day to buy or sell shares directly with a mutual fund company. ETFs can be bought and sold throughout the trading day whenever the stock exchanges are open. Any way you can trade a stock, you can trade an ETF. Shares can also be sold short or bought on margin. That makes these investment vehicles useful for institutional investors and traders who often need to quickly hedge equity positions. One difference between ETFs and traditional open-end mutual funds is that ETFs do not necessarily trade at their net asset value (NAV). That is the combined market value of the underlying security and...

The Future of ETFs

The ETF market is moving at such speeds that today's unique innovations will likely be overshadowed by tomorrow's new and bold idea. The opportunity for new ETFs is limited only by the imagination and ingenuity of the minds of those who create them. Here are some categories for growth Figure 1.2 New ETFs Launched by Year Figure 1.2 New ETFs Launched by Year Inexpensive hedge fund ETFs could be an era of opportunity for fund providers. Hedge fund investing is a hot topic in the news today, and the opportunities for investment are moving downstream toward individual investors. Academics have already simulated the returns of sophisticated hedge fund strategies, using widely traded derivatives such as futures and options. Those are the tools ETF companies can use to create synthetic hedge fund strategies for the masses. Are you buying or selling a home Home price ETFs that track the housing market may be coming soon. There are already indexes that track housing markets, and derivatives...

ETFs to the Rescue

ETFs avoid persistent premiums and discounts inherent in closed-end funds because the pioneers petitioned the SEC to allow ETF managers to create or redeem shares during the day as needed. To avoid self-dealing, however, an independent third party initiates the arbitrage trades and oversees the distribution of newly created ETF shares. The third party also decides when new ETF shares will be created and when existing ETF shares will be redeemed.

ETFs And Indexing

ETFs and index investing combine the right product with the best strategy. Let's examine the popular and original ETF SPDR SPY versus the Vanguard S& P 500 Index fund. The only difference is in fees where SPY charges .10 percent per year while Vanguard charges .18 percent. Advantage SPY.

Lower Taxes on ETFs

Holding ETF shares in taxable accounts can lead to a lower annual tax bill than if you owned a similar open-end mutual fund. The tax benefit is a byproduct of the authorized participant (AP) arbitrage mechanism described in Chapter 3. The next few paragraphs explain a specific tax advantage inherent in ETFs and other exchange-traded portfolios. The redemption of creation units by authorized participants creates an important tax benefit to the holders of ETFs in taxable accounts. It rids a fund of gains that may otherwise eventually have to be distributed to taxable shareholders, and they would have to pay taxes on those gains. The selection of tax lots is perfectly legal and is practiced every day. To illustrate the power of the ETF tax benefit, we need only to examine 2006. The stock market was up about 15 percent for the year. However, very few U.S. equity ETFs pay any capital gains and those that did were smaller funds, and they paid a minimal amount. The creation and redemption...

International Etfs

For U.S. investors initial international ETF availability was confined to single-country ETFs. Originally offered by Morgan Stanley under the WEBS name for World Equity Benchmark Shares and now part of the iShares family, they were larely ignored as the U.S. market boomed in the late 1990s. Why go abroad when markets are roaring at home New product engineers started rolling out new ETFs to accommodate increasing international ETF demand. Europe, Asia & Far East ETF EFA allowed investors to buy one ETF that gave them exposure to many more established global stock markets. EFA was launched in 2001 and from its low of 2003 rallied 170 percent by early 2007. In fact, EFA is now the second highest capitalized ETF listed, a reflection of the popularity of this trend. Given the popularity of EFA and some Emerging Markets it didn't take Wall Street long to issue more regional ETFs. Emerging Markets ETF EEM wasn't issued until 2003, but it, too, is one of the most popular ETFs issued as...

Inverse Etfs

One of the promoted benefits of ETFs is the ability to short them and do so without an uptick.* Unfortunately for many retail investors, being able to short available ETFs was nearly impossible for those beneath the top 10 or so in trading volume. *The rule dating from the 1929 market crash designed to prevent momentum driven shorting. ETFs were exempt from this rule, but soon many stocks will too be given recent SEC proposals and comments. There are other issues with hard to short ETFs. Stock specialists are a part of the process in accommodating retail short requests. Sometimes they're just not interested in finding stock from their order book to provide to the brokers. Further some ETFs are connected to more obscure indexes where there are no futures contracts or other vehicles for the specialist to offset their short position risk. to hedge your portfolio or speculate using ETFs you couldn't do it. As we outlined in chapter 1 the rollover IRA is going to be a huge market as Baby...

Currency Etfs DIRECT

Previous to currency linked ETFs becoming available, investing in those markets for retail investors was as difficult as with commodities. The only route for individual investors was through previously outlined expensive and leveraged commodity and futures pools. Currency trading was the domain for large banks and other institutions accustomed to dealing with large sums daily in the inter-bank market. Taking the lead in currency ETFs was Rydex Investments. They launched a series of ETFs including

Inverse Etfs DIRECT

A funny thing happened when trying to take advantage of shorting opportunities in various ETFs most retail investors found they couldn't. Almost every ETF issued carries the same benefit as stated on promotional material alleging you may engage in ''short selling without an uptick.'' Let's be clear, when it comes to shorting the largest ETFs issued like the Cubes and Spyders isn't a problem. But beneath the top half dozen or so in trading volume, you'll start running into problems. The lower into the bowels of the ETF roster you move the more difficult to short it is for retail investors. This is especially true for many exotic PowerShares, Claymore, and First Trust issues. But large issuers like Barclays and State Street aren't any better with some of their own issues. In fact when I complained to Barclays about our inability to short TLT they just said, ''It's a broker issue, now go away.'' Anyway given the way markets have performed since the 2002 low who wants to be short anyway,...

Market Index ETFs

Recall from previous chapters that traditional market indexes have a broader purpose than just being used as a basis for commercial investment products such as ETFs. Market indexes are used in economic analysis, in asset allocation studies, and as a yardstick to measure the performance of active managers against. The following information offers brief descriptions of some market index providers. To gain a better understanding of those indexes and the ETFs benchmarked to them, visit each provider's web site and read the prospectus of an ETF that follows the index. Provider web sites can be found in Appendix B.

Industry Sector ETFs

Industry sector ETFs are a dynamic and growing market. The number of ETFs that track industries and the depth of the offerings continue to increase. More global industry ETFs are also making their way into investors' portfolios as the world becomes flatter. There are many uses for industry ETFs. One basic use is to fill an industry gap in a portfolio that is not covered by other investments. Another use is to gain greater exposure to an industry sector that you expect to outperform the broad market. A third use is to use the funds as a hedge against a concentrated stock position. That is accomplished by shorting an industry ETF short and thereby reducing industry exposure in a portfolio. Whatever the use an investor has for industry sector ETFs, there are plenty of funds to choose from. More than one quarter of all equity ETFs are industry sector funds, and the assets in those funds total about 10 percent of the total assets in all ETFs. One of the most popular industries for ETF...

Special Equity ETFs

V pecial equity is an interesting category of ETFs. They represent unique, a little quirky, and sometimes expressive investment strategies. These funds make a statement. Some say, ''We are environmentally friendly'' others say, ''We can cure the world's diseases'' and still others say, ''We know a new way to beat the market.'' Whatever the message of the ETF, it is sure to be different from broad-based market index ETFs. Every special equity ETF is based on a customized index, and that alone makes a statement higher fees. The expense ratios of special equity ETFs are about three times higher than the average market index ETF. Although the costs are comparatively high to other types of ETFs, special equity ETFs are still only half the cost of comparable open-end mutual funds that have similar investment strategies. Six examples of special equity ETFs types are provided in this chapter. There are many more not covered and those are listed in the database link at www.theetfbook.com. The...

Stock Analyst ETFs

Wall Street employs thousands of securities analysts who attempt to select superior investments through fundamental and technical analysis. So, why shouldn't they have their own indexes and ETFs that track them They do now. Claymore has teamed up with Best Investors Research (BIR) to offer a series of ETFs based on Wall Street analyst research. BIR compiles data from five leading independent research firms and creates an overall master list. Each research company ranks its stocks on a 10-point scale on multiple fundamental factors including valuation, leverage, earnings growth, and price momentum. The BIR research team produces the master list by blending the individual rankings of each independent research company to establish a composite score. Several ETFs are formed from the master list. The Claymore BIR Leaders 50 (symbol BST) follows the BIR Leaders 50 index, which represent the stocks with the highest rankings. The Claymore BIR Leaders Mid Cap Value (symbol BMV) and the...

Sector Rotation ETFs

Sector rotation strategies are in many ways the opposite of thematic investing. In contrast to thematic investing, where investors hold narrow slices of the market and wait for long-term gains, sector rotation ETFs frequently shift money from one industry sector to another.

Hedging with ETFs

Hedge funds may be fine for those with a bankroll, but ETFs may soon be the poor man's hedge fund. Right now, ETFs give you the building blocks to construct your own simple hedging strategies. But I believe some day there will be sophisticated hedge fund ETFs that anyone can purchase. Launching a sophisticated hedge fund in ETF format may be a ways off. However, today firms are replicating hedge fund returns with ETFs by employing computer models that combine assets in a way that mimic hedge fund returns. Goldman Sachs, Merrill Lynch, and JPMorgan are all working in the space, and IndexIQ is hoping to launch a synthetic hedge fund-of-funds that will use portfolios of ETFs to track the performance of the ten investable Tremont Hedge Fund subindexes. The group plans to offer low-cost mutual funds and separately managed accounts that will track each of the ten indexes. Hedge funds may not be your interest. But here are a couple of ways you can use ETFs today to hedge events in your life....

Using EtfsOr Futures

The use of ETFs or index futures greatly increases an investor's flexibility to manage portfolios. Suppose an investor has built up gains in individual stocks but is now getting nervous about the market. Selling one's individual stocks may trigger a large tax liability. But by using ETFs (or futures), a good solution is available. The investor sells enough ETFs to cover the value of the portfolio that he seeks to hedge and continues to hold his individual stocks. If the market declines, the investor profits on his ETF position, offsetting the losses of the stock portfolio. If the market instead goes up, contrary to expectation, the loss on ETFs will be offset by the gains on the individual stock holdings. This is called hedging stock market risk. Since the investor never sells his individual stocks, he triggers no tax liability from these positions. Another advantage of ETFs is that they can yield a profit from a decline in the market even if one does not own any stock. Selling ETFs...

Gold and Silver ETFs

Speaking of taxes, a second disadvantage of investing directly in gold and silver is a higher tax bill if you sell shares at a profit. Unlike the 15 percent maximum capital gains on equity ETFs held more than one year, gold and silver investments are considered collectibles. As such, gains are taxed at the higher 28 percent maximum capital gains rate. Check with your tax adviser for changes to the tax code.

Currency ETFs

Rydex Investments launched the first currency ETF, the Euro Currency Trust on the New York Stock Exchange in December 2005. Rydex has since added more ETFs benchmarked to other currencies. Those currencies include many of the United States' largest trading partners. Each ETF holds a different foreign currency with an overseas branch of JPMorgan Chase Bank. The funds track the price of their underlying currency based on the Federal Reserve Noon Buying Rate. In contrast, the IRS considers any and all currency gains as ordinary income. That means any and all gains on CurrencyShares ETFs are subject to ordinary income taxes, which is at 35 percent today.

Rebalancing ETFs

Global markets go up and global markets go down, and they do not always go in the same direction at the same time or by the same amount. The ETFs in a portfolio that represent different asset classes in your portfolio will shift from their original allocation, starting the day after you purchase them. ETFs need to be rebalanced back to their targets regularly so the drift does not become too large. It is a good idea to rebalance at least annually, especially if the markets have been particularly volatile. The easiest way to do rebalancing is to pick a time during the year when it will always be done. For example, you can use the first week in January or your birthday. Another method is to check the allocation of the portfolio occasionally to see whether your ETFs are off target by a certain percentage. Five percent is reasonable, for example, when market forces cause a 50 percent stock and 50 percent bond portfolio to be a 53 percent stock and 47 percent bond portfolio. 1. Do not...

Create Your Own ETF Hedge Fund

''If you're thinking about building a portfolio of ETFs, David Fry's expertise can help '' ''In Create Your Own ETF Hedge Fund, Dave Fry channels his vast industry experience and keen insight into a practical and useful guide that will help investors effectively use ETFs as building blocks for their investment portfolios. Fry's description of how the markets developed along with the evolution of the participants and their incentives provides the context to further understand the relative effectiveness of ETFs, why ETFs have experienced such accelerated growth, and positive long-term prospects for the ETF industry and the investors who use them.'' Kevin Rich, CEO, DB Commodity Services LLC, a wholly owned subsidiary of Deutsche Bank AG ''David's immense experience and expertise shine through in this highly enjoyable and invaluable insight into the evolution and use of ETFs, a necessary tool in the expanding universe of global investment.''

Exchange Traded Portfolios

The Wall Street Journal lists several types of exchange traded portfolios in their ''Money & Investing'' section. I prefer the phrase ''exchange traded portfolios'' because it better describes what is covered in The ETF Book. Several investment products discussed in these chapters are not ''exchange traded funds'' by the strict definition of the word. But those investments do act like ETFs, trade like ETFs, and are often referred to as ETFs in the investment industry. One example of an investment product that is not a fund by definition is an innovative security from Barclays Bank called iPaths. These unique investments are not ETFs they are Exchange Traded Notes (ETNs). ETNs are unsecured debt obligations of Barclays Bank that track the performance of certain market indexes. Debt usually means interest is paid, but that is not the case with ETNs. These unique securities pay no interest, no dividends, and have no performance guarantees. ETNs track the total return of markets, and...

The Growth of the ETF Marketplace

The ETF marketplace is growing at a torrid pace, and that growth will likely continue for a number of years to come. ETF issuance has expanded exponentially every year since 2000. There were over 1,000 ETFs trading on the U.S. markets by 2008, with assets well over 1 trillion in investor dollars. That is 20 percent of the value of traditional open-end mutual funds. By 2010, there could be close to 2,000 available ETFs on U.S. exchanges, with assets nearing 2 trillion. It is feasible that the number and asset level of ETFs could equal that of open-end mutual funds over the next ten years, and that could be a conservative estimate. ETFs have the potential to become the largest segment of the mutual fund marketplace by 2020. You, as an informed investor, should know what makes ETFs unique, how they work, where to get the information on new funds, and which funds may help you achieve your financial objectives. That is what The ETF Book is all about.

ETF Selections

Chapter 11 goes global by expanding the scope into international equity markets. Global equity ETF issuance is growing as more international indexes are created and U.S. stock exchanges form global alliances. Emerging country ETFs are expanding into parts of the world that were once very difficult to gain access to. Chapter 13 introduces the interesting field of special equity ETFs. These unique funds include theme investing, sector rotation strategies, leveraged ETFs, and short funds. The theme investment ETFs section covers a variety of areas, including clean energy, infectious disease, social responsibility, and corporate dynamics. Leveraged and short funds are used to market hedge risk and make leveraged market bets in one direction or another. They can be useful when trying to hedge an illiquid stock position. Chapter 14 covers fixed income ETFs, including government bonds, corporate bonds, and preferred stocks. Fixed income ETF development was slow for several years. Fund...

Indiana University Kelley School of Business Indianapolis

In Chapter 4, Gary Gastineau describes how short selling exchange-traded funds (ETFs) can mitigate the risks associated with shorting individual stocks. For example, it is essentially impossible to suffer a short squeeze in ETF shares because the number of shares in an ETF can be increased on any given trading day. A second advantage is that the uptick rule does not apply to ETFs. On the NYSE exchange, this rule means that a short sale may only be done on an uptick or a zero-plus tick that is, a price that is the same price as the last trade, but higher in price than the previous trade at a different price. On the NASDAQ, you cannot short on the bid side of the market when the current inside bid is lower than the previous inside bid (a downtick). A third advantage that Gastineau discusses relates to hedging with ETF shares instead of derivative contracts. Derivative contracts have limited lives. The most active contracts in any futures market are the near month and the next settlement...

Acts like a Fund Trades like a Stock

Assume for a moment that you have decided to buy an S& P 500 index fund. There are many funds available that track the return of the S& P 500, including open-end mutual fund and ETFs. You have narrowed your search down to two candidates the open-end Vanguard 500 Index Admiral Shares (VFIAX) or the iShares S& P 500 ETF (IVV). How similar are these funds and what makes them different from one another The first and most significant difference is how investors acquire shares of each fund. VFIAX is an open-end fund, and its shares trade directly with Vanguard, the mutual fund company that manages the fund. IVV trades on a stock exchange. Shares are purchased from other investors and sold to other investors. At no time does an individual investor buy ETFs from a fund company or sell back to a fund company. Shares of an ETF are always purchased through a brokerage firm on a stock exchange. The shares you buy already exist in someone else's portfolio. They are not created for you by...

Closed End Fund Issues

Chapter 1 covered a short history of mutual fund investing, including the problem of using closed-end funds (CEF) as a market hedge. Both CEFs and ETFs trade on the stock exchange at prices that are independent of the underlying securities in the funds. Unlike an ETF, a CEF frequently develops large and persistent price differences between the price of a fund and the intraday value of securities and cash that compose the fund.

The Expanding Exchange Traded Universe

Investment Company Act of 1940 regulates the operations of investment companies, including open-end mutual funds. ETFs that are organized under the 40s Act are technically created as open-end mutual funds. To avoid confusion, the SEC mandates that ETFs issued as 40s act funds should be called exchange-traded funds rather than open-end mutual funds.

ETF Benefits and Drawbacks

Exchange-traded portfolios take the benefits of mutual fund investing to the next level. Compared to traditional open-end funds, ETFs offer flexible trading, lower operating costs, greater transparency, and better tax efficiency in taxable accounts. There are drawbacks, however, including trading costs and learning complexities of the product. Informed investors agree that the pluses of ETFs overshadow the minuses by a sizable margin. In this chapter we will review the benefits and drawbacks of ETFs, including the unique tax advantage inherent in each structure. By the end of this chapter, you should have a clear understanding of the advantages ETFs have over traditional mutual funds and some of the disadvantages. Then you can decide whether they fit with your investment plan.

Buying High and Selling

ETFs have two prices, a bid and an ask. Investors should be aware of the spread between the price they will pay for shares (ask) and the price a share could be sold for (bid). In addition, it helps to know the intraday value of the fund when you are ready to execute a trade. At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business. Make sure you know what an ETF's current intraday value is as well as the market price of the shares before you buy. Chapter 21 has tips to help cut down on ETF trading spreads, fees, and brokerage commissions.

RWM [short Russell 2000

These six ETFs can be used by investors where they are highly correlated to portfolio exposure and hedging or speculative strategies may be employed. The good news for most investors is that now they don't have to deal with complex options strategies and margin issues that are off-putting to even sophisticated investors. for their hard work. Historically, ProFunds and Rydex Investments, both located in Maryland, also maintained an ongoing competitive relationship in unique but conventional mutual funds specializing in inverse and leveraged funds. And, as is typical of their relationship, Rydex Investments has quickly followed suit by filing for an array of similar ETF issues 66 in all that should have some approved in 2007 with the balance in 2008. Both Rydex and ProShares are looking to file inverse and leveraged issues for fixed income and international ETFs. In fact, Rydex has already obtained SEC exemptive relief covering international ETFs. Once both companies have completed the...

ETF Share Creation and Redemption

Etf Creation Redemption Mechanism

The creation and redemption process that sets ETFs apart from all other mutual funds starts when an investment company sponsors a new fund. First, they record the fund's investment objective and then submit a detailed filing to the SEC for approval. The filing contains legal information about the fund, including fees, objectives, risks, symbols, and how it is responsible. That information is eventually used in the ETF's Prospectus and Statement of Additional Information. Among many other items, it discloses how much shareholders will pay for investment management and administrative costs. ETFs track securities indexes, the only exception being actively managed ETFs that are forthcoming (see Chapter 5). Most ETF companies license their indexes from an outside vendor such as S& P, Russell, Dow Jones, and MSCI. In addition to those big names, A useful index for benchmarking has clear procedures for determining index constituents and the weighting of those constituents. The methodology...

With Growth Come Other Problems

The combination of rapid ETF issuance and the growth of electronic trading on exchanges has combined to create one problem that may well act as a brake on new ETF issuance, especially for more create products. Traditionally, stocks traded on the New York and American stock exchanges were handled by a specialist, who was, at least theoretically, responsible for maintaining an orderly market for the shares. But with the floors losing market share to electronic trading networks, the specialist firms have shrunk dramatically, laying off staff and compromising their ability to fulfill their function. For the big, liquid ETFs, that's not a problem. For the others, it can be. subsidiary of Bear Stearns , making a market in the ETFs, took a holiday leaving investors wanting to trade either security abandoned. Oil prices were dropping then and those investors wanting to buy the bearish ETF were foiled as prices for it and the bullish issue inexplicably rose. While the ETFs in question...

Disruptive Technology Indeed

Just recently I listened to an interview with a hugely popular TV stock market pundit. He was being asked about ETFs and he, as a diehard stock jockey, was quick to put them down. He argued incorrectly that if you buy ''an'' ETF based on a sector, you really haven't diversified your portfolio. Well, how silly Most investors don't just buy one ETF linked to one sector, but buy a range of them to achieve appropriate diversification. you put stars on a passive index You can't. And there's the rub business-wise. Now Morningstar has put star rankings on a few of PowerShares Quantitative Intellidexes, which many in the investment community believe are quasi-actively managed ETFs. However, they, too, are tied to an index that the ETF tracks making ranking them difficult since to what are they compared The major financial advisory firms including the brokerage, financial planning, insurance, and banking industry are all hesitant about ETFs since they must find creative ways for firms and FAs...

Securities Act of 1933 Exchange Traded Portfolios

Grantor trusts trade on a stock exchange like the 1940 Act ETFs. Unlike ETFs, though, grantor trust investors have voting rights in the companies composing the trust. That gives unit holders a say in The first iPath ETNs were issued by Barclays Bank PLC in 2006. The purpose of iPaths is to create a type of security that combines both the aspects of bonds and ETFs. Rather than buy a share of a fund's indexed assets, ETNs shift index-tracking risk to Barclays. ETNs are registered under the Securities Act of 1933 because they are a security issued by a bank, not an investment company or UIT. Outside of the tax treatment and legal registration, the difference between ETNs and ETFs comes down to credit risk versus index tracking error. An ETF investor has virtually no credit risk from a fund collapsing. ETF investors are always entitled to their share of the creation unit assets. On the other hand, an investor in iPaths may not receive the return he was promised. An ETF has a tracking...

Characteristics of a Good Index

The CFA Institute guidelines are important and relevant, but they are not rules. It is clearly evident to the casual observer that many index providers to ETFs have shifted far away from the guidelines to creating customized indexes for the purpose of commercialization. I am not implying or suggesting that any or all ETFs that follow customized indexes are poor investment choices. Nor am I suggesting the ETFs that follow only market indexes are the best choices. To the contrary, there are some excellent ETFs benchmarked to customized indexes and there are other, less-than-desirable ETFs benchmarked to market indexes. The purpose of this section is to teach you about different index methodologies and how those differences may affect your portfolio. As an informed ETF investor, it is prudent to dig deep into the indexing methodology so that you can make an informed investment decision about the ETFs you are interested in.

Uses of Market Indexes

Market indexes are the primary benchmarks for index funds based on the value of securities invested in them. More money is benchmarked to market indexes worldwide than any other type of custom index strategy. That includes the ETF marketplace. Ironically, there are far more ETF tracking custom indexes than market indexes. The number of custom index ETFs outstanding in an SEC registration outnumbers market index ETFs by about two to one.

Different View on Indexes

Custom index providers have a different view of the definition of an index. They define an index as any rules-based investment strategy that can be packaged and licensed into an investment product. This definition muddyies the water for investors because it is too broad and it has created much confusion. However, that benefits ETF firms that use custom indexes. Those firms are trying to channel money destined for market index ETFs into their own custom index ETFs by inferring that the old definition of an index is inferior or obsolete.

Rule 501 Definitions and Terms Used in Regulation D

Also an interesting result of the survey is that GenX millionaires were more apt to own ETFs versus Mature Generation age 61+ . And, GenX millionaires are more likely to own Emerging Market funds, managed futures, and high-yield bond funds. Most of these are also staples within many hedge funds.

Index Strategy Boxes

Index Strategy Boxes makes index security selection and security weighting methodologies easily identifiable. Knowing how securities are chosen and allocated within an index can explain a lot about how it will move in relation to general market trends. The information provided by the Index Strategy Box categorization and accompanying tables will greatly reduce the time it takes to analyze and select the ETFs for your portfolio.

Figure 71 Index Strategy Boxes

Passive indexes typically hold enough securities so that the basket has similar risk and return characteristics in relation to the market as a whole. Also, many ETFs do not hold all the securities that compose the index, although it is the intent of the ETF manager to track the index as closely as feasible. Unlike full or free-float indexes, liquidity weighting is based on the actual value of securities that trade on a market. Although there may be a large number of shares that could trade based on a securities float, it is the market value of the trades that is the most important component for ETF companies and authorized participants. Liquidity weighting is a particularly useful method of managing index ETFs in hard-to-trade foreign markets.

Mutual Funds Adopting Some Hedge Fund Strategies

According to Morningstar there are now more than 100 mutual funds currently offer some variation on the traditional hedge fund long short or market neutral strategy, but it's hard to tell how many are using ETFs, rather than stocks, bonds and derivatives, a category that includes both conventional equity and index options, and more complex swaps keyed to the performance of, for example, an investable hedge fund index. Many funds in this category like the higher beta volatility of individual stocks versus an ETF. For example, the best performing stock within a sector will generally outperform the worst performing stock within a sector by a significant margin. So a correct long short bet within a sector will, assuming the same level of risk, outperform, the ETF's directional bet on the overall sector. Experienced mutual fund managers in this area will likely continue to use what's worked best for them in the past. However, given all the new ETF issues available, managers skilled at...

Figure 75 Capitalization Weighting Index

A constrained (or capped) index simply means that no security is allowed to go above a certain percentage in the index, that is, a maximum of 5 percent or 10 percent per security. Constrained indexes are designed to keep ETFs within strict SEC mutual fund diversification requirements.

Powershares Actively Traded

No ETF provider has been more active in issuing novel and cutting edge ETFs than PowerShares, which was acquired by large mutual fund provider and distributor AMVESCAP in 2006. They have led the way in designing quasi-actively managed indexes Intellidexes in conjunction with the American Stock Exchange upon which they've issued dozens of ETFs. Most ETF market pundits have accepted their Dynamic Intellidex indexes. Others have wanted to let these uniquely structured ETFs demonstrate their worth over time and even a variety of market cycles.

Index Security Selection

Ndex Strategy Boxes categorize indexes based on their construction and maintenance rules. The rows represent security selection methodologies and the columns represent security weighting methods. Knowledge of an index's security selection and security weighting mythology are major steps toward understanding the performance of ETFs that track the index.

Figure 82 Russell Index Security Selection

Some ETFs follow baskets of securities that are selected once and never changed. An example of ETFs using a buy-and-hold strategy is Holding Company Depositary Receipts (HOLDRs). Stocks in HOL-DRs are selected once on the basis of a passive method. Then the basket becomes an unmanaged trust (see Chapter 3 for details). The advantage of this method is its extremely low cost (there is no management fee). The disadvantage is that no new securities can go into a fund. Once the stocks are selected at inception, they become a fixed buy-and-hold basket. Stock can be taken out of the basket because of mergers and acquisitions, but no new companies can replace them.

Figure 83 Filtered Security Selection

Screened indexes differ from passive indexes in that there is a limited hierarchy, if there is any at all. The various indexes never add up to the starting universe because the undesirable securities are permanently eliminated. Those securities do not go into an index of undesirables. For example, a provider of socially responsible indexes does not maintain socially irresponsible indexes. There may be socially irresponsible indexes and ETFs in the future, but they will not be licensed by the companies that sell socially responsible ones. Figure 8.4 illustrates how an index provider permanently eliminates securities through screening. Custom indexes based on screens are not market indexes and products that follow them should not be bought under the assumption that they will outperform a market index. ETFs that follow filtered indexes are investment products designed for distribution to a specific audience and typically for a specific purpose. That being said, many ETF companies that...

Convergence Well Underway

There have been dramatic changes in the investment marketplace. The explosive growth of ETFs has included many diverse issues. These new issues have done much to open markets previously either difficult for retail investors to enter or impossible. These would include unleveraged commodity and currency sectors, inverse series, actively managed, private equity, and globally focused issues. Mutual funds have found a way to utilize ETFs utilizing hedge fund like structures and strategies including many long short funds mushrooming into existence. Mutual funds have also found a way to offer Alternative Investments through the Rydex Managed Futures Fund which allows investors another important and typical hedge fund component never previously available to retail investors. And zero commission structures allow for cost-effective trading previously only a province of major institutional traders and large hedge funds. In June 2007, according to the Investment News article ''Hedge Funds Face...

Figure 84 Screened Index Security Selection

Stocks that pay regular dividends became quite popular after the tax law changes of 2003. The top tax rate on stock dividends was lowered to 15 percent if the shares were held more than 60 days. In addition, value stock investing became very popular in the first half of the decade after the growth stock bubble collapse from March 2000 to March 2003. Those two events lead to the creation of many dividend screened indexes followed by the launch of several ETFs that follow those custom indexes. WisdomTree Investments, Inc., introduced the first family of domestic and global dividend weighted indexes and ETFs in May 2006. The WisdomTree dividend indexes are composed of companies that pay regular cash dividends and meet other liquidity and capitalization requirements. Stocks are fundamentally weighted (see Chapter 9) in the indexes to reflect the proportionate share of cash dividends projected to be paid by each company in the coming year. In 2007, WisdomTree introduced...

Quantitative Security Selection

Before we move on, it is important to note that quantitative index providers say their returns may not beat the market nominally, but by applying a quantitative risk model to security selection, they hope to achieve better risk-adjusted returns. Adjusting the returns of an index for risk can be done in many different ways. One of the most popular methods, the Sharpe Ratio, is discussed in Chapter 19. ETFs that follow quantitative security selection have definite telltale characteristics. I list here five of the most common ones.

Figure 86 Quantitative Index Security Selection

A fourth characteristic of nearly all quantitative ETF providers is that they advertise comparison of, charts in marketing material that imply that their indexes have achieved superior performance over some benchmark. Realize that these charts do not show the return of the ETF, because most ETFs using quantitative strategies have not been around long enough. They show instead the hypothetical returns of the index, which in several cases do not actually exist either. Does that hypothetical performance have any relevance Not to a knowledgeable investor, but perhaps the ETF companies are hoping naive investors would not know the difference. The fifth characteristic of quantitative ETF providers is very important to investors because it is about costs. Universally, ETFs that employ quantitative methods charge the highest fees of any type. Those fees are about three times higher than ETFs that select stocks passively and twice as high as ETFs that follow filtered...

Index Security Weighting

Index providers allocate securities in their indexes using three basic methods capitalization weight, fundamental weight, and fixed weight. A capitalization weighted index bases the allocation on the relative market value of each security in that index. Fundamental weighted indexes use financial ratios or qualitative factors to allocate among index constituencies. Fixed weighting assigns a set weight to each security in an index. Leverage, short (inverse), and long-short ETFs are also considered fixed weighted indexes because the weighting of the entire index is changed by a fixed amount.

Types of Passive Security Weighting

There are four basic types of capitalization weighted indexes full cap, free float, constrained (capped), and liquidity. The difference between full cap and free float is that the former includes the total value of all securities outstanding while the latter includes only the value of shares that are available in the public markets. Capped indexes preclude a few securities from dominating a narrowly defined index. Liquidity indexes are useful in thinly traded markets to ensure there is enough trading volume of securities to physically create investment products such as ETFs.

Fundamental Weighting

Dividend weighted indexes have become very popular recently. In the past few years, dozens of ETFs and open-end mutual funds have been launched that focus on some aspect of dividend payout. A few indexes screened companies for cash dividend payments and then weighted those companies based on the dividend yield relative to all other dividend payers. Dividend-paying companies tend to have value characteristics over non-dividend-paying stocks. That has strong implications for dividend index risk and return characteristics (see the analysis that follows). example, quarterly dividend payouts change as companies increase, maintain, or cut dividends. Consequently, fundamental weighted indexes need to be rebalanced frequently to ensure their integrity. Rebalancing is a cost to the portfolio because securities must be traded by the fund manager. Higher maintenance costs may be the reason why ETFs that use fundamental weighting charge more money than an ETF that uses passive security selection...

Limitations of Fixed Weighting

The decision by the equal weight index providers to not rebalance daily helps cut down on transaction costs and the ETF manager's time, and that helps make the practice acceptable. However, investors in equal weighted index ETFs need to know that they are not getting true equal weighted results because between quarters (or longer) the indexes can pick up substantial tracking errors.

Pricing ETF Shares and Components

Like stocks, ETFs always have two prices a bid and an ask price. The price you will receive depends on whether you are buying (ask) or selling (bid). The trading spread is the difference between the bid and the ask. A small trading spread of a few pennies means the ETF ETFs is trading close to its intraday value and is typical of the 50 or so most active ETFs. Spreads can become wide when there is uncertainty in the markets, or the underlying securities have less liquidity. When the international markets are closed, trading in ETFs that invest in international stocks will have wider spreads than those that trade in U.S. stocks. The spread in some ETFs can be persistently larger than the spread in others. That is due to the securities that make up the underlying ETF. Trading spreads of ETFs reflect a compilation of the trading spreads in the underlying securities of that fund. The trading spread of an S& P 500 ETF will be just a few cents because the stocks that make up the S& P...

Figure 92 Size Changes with Equal Weighting

Weight ETF has a share-weighted market capitalization of only 14 billion. That put share-weighted equal weighted ETFs at less than one-third the average market capitalization of the S& P 500 index ETF. A share-weighted market cap of 14 billion was just a sliver away from being in the mid cap fund category according to Morningstar's size rating system.

Style Performance Characteristics

Value and mid cap indexes exhibit different risk and return profiles than broad market indexes. To that extent, the way an index is weighted can have a profound impact on its performance. Investors that select modified weight ETFs should be aware that those ETFs will not track the performance of a capitalization weighted ETF most of the time. There will be periods of underperformance and periods of outperformance. That is simply the cycle of size and value factors. Based on the data from Figure 9.4, you will understand why there were no ETFs launched in the 1990s that followed modified weighted custom indexes. If one were launched in the mid 1990s, it would have performed poorly in relation to a capitalization weighted index. That means the ETF probably would not have attracted enough assets to survive the decade.

Broad Market Indexes and Style Components

The amount of information available on broad U.S. equity indexes and ETFs is so large that it could fill an entire book. Because of limited space, only a sampling of market index ETFs and custom index ETFs are discussed in this chapter. For a complete list of all U.S. ETFs, visit www.theetfbook.com for a link to the www.etfguide.com database. Index Strategy Box information is included in the ETF database.

Market Neutral Mutual Funds

Strategies aren't designed to incorporate ETFs as their dominant tools, many funds within this category use them occasionally. In what way are ETFs used Many mutual funds whether focused on market neutral strategies or not utilize ETFs for getting invested quickly in a sector. Suppose for example XYZ Fund thought the overall Tech sector was going lower. They might short the Cubes as an efficient way to put a position on immediately. Then they might target individual stocks to short within the sector that they felt were going to much underperform the overall sector. They then short those stocks closing the Cube and trade proportionately as they do so.

Russell US Equity Indexes

In 1984, Frank Russell & Company created the Russell family of stock indexes to measure the performance of active managers. Today several hundred billion dollars are benchmarked to Russell's stock indexes, and some of that money is invested in ETFs. The most popular ETF is the iShare Russell 2000, which follows an index of small cap stocks.

What Are The Most Important Safety Features Protecting Etf Short Sellers

Exchange-traded funds are a unique hybrid of closed-end and open-end investment companies. ETF shares trade like common stocks or closed-end funds during market hours and can be purchased or redeemed like open-end funds with an in-kind deposit or withdrawal of portfolio securities at each day's market close. In the United States, ETFs offer a unique level of capital gains tax efficiency and in most markets they offer a high level of intra-day liquidity and relatively low operating costs. The trading flexibility and open-endedness of ETFs offer unusual protection to short sellers. 1. It is essentially impossible to suffer a short squeeze in ETF shares. In contrast to most corporate stocks where the shares outstanding are fixed in number over long intervals,1 shares in an ETF can be greatly increased on any trading day by any Authorized Participant.2 Creations or redemptions in large ETFs like the S& P 500 SPDRs and the NASDAQ 100 QQQ's are occasionally worth several billion dollars...

Think Global Invest Global

In the United States, ETF issues geared to overseas investing has grown faster than any other sector. Popular EFA MSCI Europe, Asia, and the Far East is now the second or third largest ETF in terms of assets in the United States. Other overseas ETFs are also extraordinarily popular including ILF Latin America ETF, EEM MSCI Emerging Markets ETF, and single country funds like EWA Australia, EWJ Japan, and EWW Mexico to name just a few. Mostly listed on the American Stock Exchange AMEX , many of these ETFs, particularly in the single-country fund area have existed for quite some time but languished with little trading volume during the 1990s as investors focused on the U.S. stock market boom. Just on the AMEX alone there are more than 50 such overseas oriented issues. The New York Stock Exchange NYSE , not to be left out of the game, is becoming more competitive with dozens of new issues listed there as well. Furthermore, many overseas ETFs are becoming more specialized in subsectors...

Exchange Specific Indexes

First Trust has two unique ETFs that follow customized NASDAQ indexes. One is an equal weighted NASDAQ-100 (symbol QQEW) and the other is the NASDAQ-100 that excludes technology stocks (symbol QQXT). QQXT is an interesting fund because it excludes the stocks that make NASDAQ-100 popular. However, some investors make good uses of industry-excluding ETFs. See Chapter 20 for more details on special ETF uses. NYSE indexes track only the performance of stocks that trade on the New York Stock Exchange. There are two ETFs benchmarked to the NYSE indexes the NYSE Composite index and the NYSE 100 index. The iShares NYSE Composite Index (symbol NYC) tracks all the stocks that trade on the NYSE while the iShares NYSE 100 Index (symbol NY) tracks the 100 largest companies.

Fundamental Selection and Weighting Indexes

WisdomTree Dividend Indexes use fundamental filters to eliminate stocks that do not pay a regular cash dividend and then weight remaining stocks using dividend data. During 2007, approximately 1,500 dividend-paying stocks meet the screens from a universe of approximately 3,500 companies. WisdomTree slices the 1,500 stocks into various size indexes to create the benchmarks for WisdomTree ETFs. The indexes also use fundamental weighting. Companies that pay higher dividends by cash value have a higher percentage weight. Earnings indexes are an offshoot of dividend indexes. Wis-domTree Earnings ETFs are benchmarked to WisdomTree Earnings indexes that screen companies for positive cumulative earnings over their four most recent fiscal quarters. Since most U.S. companies have earnings, those screens allow more companies to pass through than dividend screens, thus giving investors a broader slice of the U.S. market.

Advantages of Investing Internationally

One reason the returns of foreign securities diverge with U.S. securities is due to the underlying native currency movements. International equity ETFs are quoted in U.S. dollars on U.S. exchanges even though the underlying investment in those funds may have a native currency of something else. For example, Japanese equities are valued in yen and converted to U.S. dollars before being quoted on U.S. exchanges on the stock pages of your local newspaper. The price of Japanese stocks may not change in its native currency, but they could change in U.S. dollars if the value of the dollar changes against the yen. The Japanese stock market could even be closed and ETFs that track the Nikkei and other Japanese market indexes experience sizable price movements on U.S. exchanges because of currency fluctuations. When the U.S. dollar falls in value against the yen, U.S. investors holding Japanese stocks are hedged against the decline. When the dollar rises against the yen, those same investors...

Broad International and Global Market Indexes

Broad international and global market ETFs are the topic of discussion in the first part of this chapter. These ETFs follow indexes that cover the entire globe as well as the international component, regional components, and individual country components. Broad markets also include slicing the international market horizontally into developed market and emerging market indexes. Horizontal slicing also includes global industry indexes that form the basis for global industry ETFs to be discussed in this chapter. MSCI Standard indexes target 85 percent of the free-float adjusted market cap segment of the global equity markets. The size cutoff varies somewhat across countries and regions depending on the extent of the market. To cover most of the other 15 percent, MSCI Small Cap indexes are promoted by the firm as ''exhaustively covering'' the investable small cap market worldwide. The data include both developed and emerging markets. In total, MSCI has created more than 20,000 style,...

Mutual Funds and Electronic Traded Funds

There are all types of mutual funds and electronic traded funds, and investors often choose them as alternatives to assembling their own portfolio of securities. Of course, you could have a portfolio of mutual funds too. There are proponents of mutual funds, and then there are those who favor a careful selection of stocks to address an investor's very individual requirements. In recent years, the Gold Electronic Traded Funds have emerged, and they provide a means for trading mining stocks, not just gold stocks. They are becoming popular as an alternative form of precious metal investing or to provide greater diversification outside of possession of precious metals. Unless you wish to study individual stocks, mutual funds and ETFs are a possible answer, although they need to be analyzed just as carefully. Two investment services to guide you to profits include the Global Market Investor, plugging you into the most promising global ETFs available, and the Global Mutual Fund Investor,...