How would you like to own an investment that requires little active management on your part, yet produces up to six times the return you are likely to receive by picking your own stocks?
If that sounds attractive, you might want to consider exchange-traded funds or Index Funds.
As the name implies, an "Index Fund" is a fund that invests in a group of stocks selected to closely track the performance of a stock index, such as the Dow, the S&P 500 or a more specific group of stocks - like AMEX mid-capitalized stocks or NASDAQ energy stocks only. Like mutual funds, index funds can only be traded after the close of business on a stock exchange.
There are currently hundreds of different index funds, and new ones are appearing virtually every month.
One billionaire who has started several major businesses through the years recently admitted he doesn't even bother to invest in individual stocks. Instead, he simply puts his money into ETFs or Index funds.
Since 1991 the S&P index has increased FIVEFOLD.
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Just think of what that could have meant to your investments. While the average S&P 500 stock held by the individual investor has increased by a juicy 148%, according to Index Fund Advisors, an S&P 500 index fund has returned an astounding 840% at the same time.
In other words, if you had picked your own stocks during the last 15 years, you most likely would have made about 10% a year. However, if you had invested the same money in an S&P 500 Index Fund, your returns would be nearly 60%.
An ETF Primer
Exchange-traded funds - or ETFs - are a variation on index funds and have definitely become an increasingly popular investment. In 2004, ETF assets increased by 47% to $222 billion, according to the investor service Morningstar.
The main difference between Index Funds and exchange-traded funds is that with ETFs, you can buy or sell shares whenever an exchange is open. In addition, investors are able to trade options on ETFs just as they can with common stocks, adding aggressive and defensive trading tools to their armory.
Investors can also short-sell ETFs just as they can with many common stocks. That also means you can bail out of an ETF more quickly in the event of a dramatic market correction.
ETFs don't sell shares directly to the investor. Instead, they issue them in large blocks, called " Creation Units." These are typically comprised of 50,000 or more shares and generally purchased by large institutions, which in turn split up these large initial blocks of shares and sell them to smaller investors.
ETF Performancek
The performance of Index Funds and ETFs closely follows the basket of stocks they track. For instance, when the S&P 500 goes up 10% in a year, an Index Fund that tracks the S&P 500 – such as Barclay's (IVV: AMEX) – will also tend to go up 10%. That makes exchange-traded funds a particularly easy and hassle-free method of investing during a bull market.
However, the price of ETFs is not the same as that of the underlying stocks. Rather, it reflects supply and demand for the ETF itself. Of course, arbitrage opportunities mean that the two don't get out of line often or for long.
Smart investors will easily bring the two prices back into line. But the ETF usually tracks very close to the underlying shares' value.
Lots of Variety
There are now many different ETFs and index funds to choose from, including funds that track the DOW, the S&P 500, energy stocks, emerging market stocks, Chinese stocks and Latin American stocks. The list goes on and on - and it gets larger every month. The Vanguard Group alone now offers nearly two-dozen ETFs.
Low Management Fees
One major advantage of exchange-traded funds is that management fees are generally very low - as little as 0.9% of assets compared to average mutual fund fees of 1.4%.
That means when you invest in ETFs, you can save as much as 12% a year in management fees.
ETFs are also strictly regulated by the government, so you can invest with reasonable peace of mind. Financial firms are only allowed to offer an ETF after the fund is closely examined by the Securities and Exchange Commission to ensure that it meets a long list of financial requirements.
Effectively, that means ETFs are sold by large institutional firms rather than small, fly-by-night companies.
All ETF certificates must also be cleared through the Depository Trust Clearing Corporation - the same government agency that records individual stock sales. This makes ETF transactions both transparent and highly liquid.
If you are considering an ETF, be sure to check out the prospectus or " product description." By law, the fund manager must give you this upon request.
Tax Advantages
While you own ETF shares, the composition of underlying stocks could change, and their value might rise or fall. However, you owe no taxes on them until you sell your shares.
That is due to a regulatory loophole that asserts that ETFs are created through the trading of "equivalent certificates." This is an in-kind trade and is therefore non-taxable.
While there is no way of avoiding capital gains entirely, by delaying this tax, you can accumulate wealth in an ETF until you actually sell your shares.
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