Energy Investing: The Dawn of ETFs - dummies

Energy Investing: The Dawn of ETFs

By Nick Hodge, Jeff Siegel, Christian DeHaemer, Keith Kohl

When exchange-traded funds (ETFs) stepped onto the investment scene in the 1990s, nobody was happier than individual investors. This type of investment offers you the opportunity to diversify your portfolios like traditional mutual funds without some of the hassles.

An exchange-traded fund is an investment fund that can be traded on an exchange. Like mutual funds, ETFs hold assets like stocks, bonds, or commodities, but with much more flexibility. There’s quite a difference between trading the two — look at ETFs like a mutual fund that you can trade like a stock.

With mutual funds, the price isn’t set until the end of the day, which is when the net asset value (NAV) is calculated.

To calculate NAV, first take the total value of the fund’s assets minus the liabilities and then divide that number by the total outstanding shares. The formula looks like this:

NAV = (assets – liabilities)/shares outstanding

An ETF, on the other hand, can trade higher or lower than its net asset value per share depending on market demand throughout the trading day.

The differences don’t end there. ETFs have the following key advantages over mutual funds:

  • Tax efficiency: Capital gains taxes are incurred only when the ETF is sold. With mutual funds, capital gains taxes are charged as shares are traded within the fund throughout its existence.

  • Cost and expenses: Mutual funds are actively managed by a fund manager, so it’s easy to watch their fees and related expenses stack up. Those expenses are limited with ETFs because only one transaction is involved and lower expense ratios add to your savings.

  • Flexibility and transparency: The ability to trade an ETF like a stock gives you more control over when to buy and sell. Also, ETFs must report their holdings at market close, which means you know exactly what they own. Sometimes it can take up to two months before a fund reveals that information.

  • Shorting: It’s entirely possible for investors with bearish outlooks to short ETFs. Shorting may not sit well with a long-term investing strategy, but it can offer you the chance to hedge through a short position.

Picking the proper ETF

When pitting one potential ETF against another, it’s important to compare a few key metrics to help you sort them out. Follow these simple guidelines when deciding whether a certain ETF is right for you:

  • Strategy, strategy, strategy: Because you know exactly what cards each ETF is holding, take the time to see how the ETF is positioned. In other words, do the ETF’s holdings offer you the diversification you’re looking for? Is one of the ETFs more top-heavy than the other? If you wanted more risk, you could have just gone after an individual stock.

  • Expense ratios: Effectively keeping expenses under control means all the difference with investment funds. Despite their advantage over mutual funds in this category, remember that there’s a wide range of expense ratios among ETFs. However, you also need to look beyond the management fees. Some ETFs are commission-free, which can pay off over time.

  • Discounts: Look for an ETF that’s trading at a discount to its net asset value. With enough due diligence, you’ll quickly discover that deals can be found under any market conditions if you just look hard enough.

  • Dividends: A strong yield by a prospective investment fund can be the deciding factor when evaluating its volatility. What’s more, dividends can differ greatly as you dig around potential ETFs.

  • Liquidity: You can tell that ETFs are more liquid than traditional mutual funds, but liquidity is an important factor because you can conduct these trades during market hours. The ability to quickly buy or sell a position is paramount when determining a proper entry and exit price (especially if it means buying at a strong discount!).

  • Volatility: No matter where you look in the market, some investments simply carry more volatility than others. Having a lower volatility generally attracts more investors. You can use the 200-day volatility metric to gauge how a specific ETF has performed in the past.

Never forget to thoroughly review an ETF’s prospectus before the purchase. The prospectus tells you everything you need to know about the ETF. Some ETFs send you a summary ETF instead of the entire document. The whole prospectus is nearly always available on the Internet, although you’re perfectly within your rights to request a paper copy from the company at no charge.

You can find shortcuts for sorting through the investment funds available all over the Internet. The following websites are good:

Differentiating between ETFs and ETNs

Know your note! Exchange-traded notes, commonly referred to as ETNs, are like an ETF’s twin — they appear to be identical, can easily confuse newcomers, and rarely can a small investor tell the difference between the two. An ETN is a note that’s a liability of the issuing company. Basically, it’s a debt note that’s linked to the performance of a specific market benchmark or strategy.

While an ETF is a basket of assets that track an index and parts of a sector, an ETN focuses on a particular niche of a sector. Think of it like a bond, where it guarantees investors the return on the index with a specific maturity date — and there are no tracking errors when it comes to ETNs.