David Twibell

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What are exchange traded funds, and why do they beat most mutual funds?

Exchange Traded Funds: Why They Beat Most Mutual Funds

There's been a lot of recent talk in the financial press about exchange traded funds, or ETFs. Some of you may already be familiar with them, but my guess is for most individual investors, the term "exchange traded fund" is just another bunch of financial gibberish - vaguely familiar but completely meaningless. Well, to artlessly coin a phrase from the movie Braveheart, "we'll 'ave to remedy that then, won't we."

In financial-speak, ETFs are hybrid investment vehicles that combine the trading flexibility of individual stocks with the diversification benefits of mutual funds. ETFs possess characteristics that make them particularly suited for investors who want a low-cost way to obtain broad exposure to specific sectors of the financial markets.

That's mouthful, but what it really means is that ETFs are like mutual funds, only better. And they are better for several reasons.

First, ETFs are cheaper than mutual funds.
ETFs have extremely low annual expenses, often less than 20 basis points (0.2%). Contrast this with actively managed mutual funds whose disclosed expenses average over 135 basis points (1.35%) - and this doesn't even include the additional 2% to 5% in loads, 12(b)-1 marketing fees, transactions costs, and soft dollar expenses mutual funds charge you but never disclose (except in the teeny-weenie small print nobody ever reads).

Second, ETFs have a lower turnover than most mutual funds.
Because ETFs are passively managed and consist of a fairly static basket of stocks, they generally have little or no portfolio turnover. Contrast this with many actively managed mutual funds that can turn their portfolio over several times during the course of a year - incurring transaction fees on each purchase and sale.

Third, ETFs are more tax-efficient than mutual funds.
Unlike actively managed mutual funds, which annually spin off taxable short-term gains and distributions to shareholders, ETFs ordinarily only generate taxable capital gains when you sell them. Moreover, due to their unique legal structure, ETFs are also more tax-efficient than their passively managed index mutual fund counterparts.

Fourth, ETFs give you more flexibility than mutual funds.
They can be bought and sold through your broker without restriction during the trading day, just like a traditional stock. This provides investors with significant flexibility compared to mutual fund investors, who cannot engage in transactions during market hours.

Fifth, ETFs allow you to more easily customize your portfolio than you can with passively managed mutual funds.
Today, there are over 150 ETFs sponsored by a variety of institutions, including SelectSector SPDRs (State Street Global Advisors), iShares (Barclays Global Investors), HOLDRs (Merrill Lynch), and VIPERs (Vanguard). These ETFs focus on dozens of different market sectors, from bonds to technology, and everything in between. As a result, investors can mix and match them to achieve a desired portfolio balance, emphasizing certain sectors while staying away from others depending on the market environment.

Sixth, ETFs are more cash efficient than mutual funds.
Since ETFs don't need to maintain a cash position to satisfy redemptions, they can be fully invested in securities. This usually allows them to outperform a mutual fund with a corresponding basket of securities, but which incurs a substantial cash drag.

Finally, ETFs offer more sophisticated hedging options for experienced investors.
Because ETFs can be bought on margin or sold short like a stock, they allow experienced investors to implement sophisticated hedging, market-neutral, and other alternative investment strategies.

Exchange traded funds aren't for everyone, though. Because they are traded on stock exchanges, you incur a brokerage commission when you purchase or sell them. As a result, if you are making small regular contributions to your investing account, you'll end up being swamped in commissions.

David Twibell is President and Chief Investment Officer of Flagship Capital Management, LLC, an investment management firm in Colorado Springs, Colorado, specializing in market-neutral and contrarian investment strategies. He is a frequent contributor to several national and local publications, including Financial Planning magazine. For more information, please visit www.flagship-capital.com

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