Exchange-traded funds serve as dynamic investment option

Key Points

An ETF is simply a mutual fund that invests in an assortment of securities, much as any other fund. The big difference is that ETFs trade on a stock exchange just like equities. Because they trade like stocks, ETFs don't have their net asset value (NAV) calculated only once a day, as a mutual fund does. Instead, they undergo price changes throughout the day, as they are bought and sold just as stocks are. As a result, you don't have to wait until the next day to find out the market price of the transaction for your sale or purchase.

ETF advantages

Originally, ETFs were limited to passively managed funds that tracked an index. For example, one of the first and most widely known ETFs is called the Spider (SPDR). It tracks the S&P 500 index and trades under the symbol SPY. However, in 2008, the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs, thus widening the range of choices for investors. It's now possible to buy actively or passively managed ETFs that track almost any index in any sector or industry.

So what can ETFs do for you? As more of these funds are introduced, it becomes easier to round out your portfolio to fill any gaps in your coverage of asset classes.

Let's say you have a well-rounded portfolio of U.S. stocks, but little or nothing in foreign equities. You'd like to broaden your international coverage at low cost, but you have minimal knowledge of foreign companies and aren't confident in picking individual stocks. In that case, ETFs may well be the right solution for you.

ETFs can also help to diversify a portfolio consisting entirely of individual corporate bonds. In that case, you'd be missing out on such important investments as treasuries, mortgage-backed bonds and the all-important TIPS (Treasury Inflation-Protected Securities). By purchasing one of the bond market ETFs, you'd participate in a highly diversified selection of bonds with minimal fuss and expense. Because the costs for bond ETFs are low and they usually make monthly cash distributions, bond ETFs can be great tools for building an income portfolio. Apparently, many ETF investors agree, since bond ETFs drew bigger net cash inflows than any other ETF category in 2009 (more than $44 billion, bringing the total for that category up to $106 billion in holdings).

Battling for business

And now there's some new good news for investors in ETFs. Two discount brokerage giants, Fidelity and Charles Schwab, are slugging it out in a battle for your ETF business. It started with Schwab's announcement that it would stop charging its customers commissions for online trading of any of the ETFs that Schwab manages. In short, zero commission for buying or selling Schwab ETFs.

Fidelity quickly came back with the announcement that it would waive commissions for online trades of 25 iShares-brand ETFs for at least the next three years. It also lowered its online commission for stock trades to $7.95 per transaction. That was in answer to Schwab's slashing its rate from $12.95 to $8.95 per online trade.

Zero commissions, of course, makes ETFs even more attractive, especially for investors who practice dollar-cost-averaging - investing a fixed amount on a regular basis. Until the zero commission slugfest, it was less costly to invest in regular index funds than ETFs.

The different approaches taken by each of these firms offer a different set of benefits. Fidelity partnered with BlackRock, which offers all 25 iShares-brand funds at no commission for online trades. Schwab, on the other hand, created its own family of just eight ETFs, which charge no commission and lower operating fees than most other ETF sellers. But the fight isn't over yet. Chances are that these two firms will be jousting even further for a bigger share of the ETF market.

Of course, lower costs alone aren't sufficient reason to choose one investment over another. Before you invest in any ETF, you should follow the same precautions that you would follow with any investment. Research its history, degree of risk and expense ratio to make sure that it satisfies your own investment standards.

William Lynott is a former management consultant and corporate executive who writes about business and financial topics. Reach him at lynott@verizon.net
or at http://www.blynott.com/.