What are ETFs

  • As their name suggests, exchange-traded funds (ETFs) are investment funds that trade openly on the stock exchange. Although they have become increasingly popular of late, ETFs have actually been around since the late 1970s.
  • ETFs are structured similarly to mutual funds in that each share that an investor purchases represents partial ownership of an underlying group of securities. Investors in both mutual funds and ETFs can achieve diversification through a single purchase. However, ETFs can be bought and sold on an exchange throughout the day, whereas mutual funds can be bought or redeemed from the mutual fund company only after the close of trading.
  • Thus, ETFs combine the diversification potential of a broad portfolio with the simplicity of trading a single stock on an exchange.

The following articles debunk popular myths related to ETF investing:

 

What Yield Are You Looking At In The World Of Income Investing?

Yield to Maturity: The single discount rate that equates the present value of a bond’s cash flows to its market price. Also referred to as the internal rate of return of a bond.

This measure is perhaps the most basic to bond investors, but it does not take into account any fund-related expenses. However, it does provide investors with a glimpse into the income potential of the actual holdings of the portfolio.

Yield to Worst: The rate of return generated assuming a bond is redeemed by the issuer on the least desirable date for the investor.

Similar to the yield to maturity, this measure may be more important with bonds that have embedded options where, in certain market scenarios, the bond may be called before its maturity. This measure is often a more conservative measure than yield to maturity and is the preferred yield measure on corporate bonds and portfolios.

Implied Yield: The annualized rate of return generated by a fund’s investment in forward currency contracts. The calculation is intended to show the yield of forward currency contracts, assuming that foreign exchange rates remain constant.

This measure is most relevant for currency strategy funds. At current levels, foreign interest rates are higher than those in the U.S. For this reason, a substantial portion of a forward currency contract’s return may be attributable to returns derived from exposure to foreign interest rates. These interest rates are “embedded” in the value of the forward currency contract and cannot be separated from the spot return component of the contract. For this reason, the currency strategy funds intend to distribute any capital gains on these contracts annually.

Embedded Income Yield: Represents the annualized rate of return generated by a fund’s investments in both fixed income securities and derivatives exclusive of interest rate changes and movement in foreign exchange spot rates. The calculation is intended to capture the fund’s potential to earn income return over the next year given current holdings and market conditions. The embedded income yield will differ from the portfolio’s yield to maturity, due to the incorporation of derivatives in the embedded income yield.

This term is used to give investors an idea of what the income potential of the fund is by combining the yield to maturity of bonds and any impact on income potential from derivative positions (such as forward currency contracts). The term will also be relevant for the rising rate suite of products where the implied interest rate on the futures contracts is offset against the yield to maturity of the bond portion.

SEC 30-Day/Standardized Yield: A standard yield calculation developed and required by the Securities and Exchange Commission (SEC). It is based on the most recent 30-day period covered by the fund’s filings with the SEC. The yield reflects the dividends and interest earned during the period, after the deduction of the fund’s expenses.

This measure is required by the SEC.

Distribution Yield/Indicated Yield: Calculated by annualizing the most recent fund distribution and dividing by the fund’s current NAV. The yield represents a single distribution from the fund and does not represent the total returns of the fund.

Many income-focused investors may be sensitive to how much net yield is distributed to fund shareholders. This amount is perhaps the most difficult to forecast in an exchange-traded fund.

12-Month Yield: The sum of the per-share dividends over the last 12 months, divided by the fund’s current net asset value (NAV).

In short, this is a 12-month trailing calculation of the distribution yield, mentioned above.

While no single yield can give investors a completely transparent picture of a fund’s income potential, the values listed above may provide some guidance to help them make their decisions.

 

Commonly Used Acronyms In The ETF World:

For Exchange-Traded Fund (ETF) users and general investors alike, there are an abundance of acronyms, used regularly to define everything from groups of countries and products, to financial and trading terminology. While these terms are crucial to one’s daily understanding, it can often be difficult, confusing even, to keep track of their expanded meanings.

Here‘s a list of the most frequently used acronyms, expanded and explained, to make your everyday Wall Street Journal reading easier.

ETF Landscape Terms:

AP: Authorized Participant

  • An entity, usually an institutional investor, that submits orders to the ETF for the creation and redemption of ETF creation units.

CU: Creation Unit

  • A specified number of shares issued by an exchange-traded fund (ETF) in large blocks, generally between 25,000 and 200,000 shares. The authorized participants that buy creation units either keep the ETF shares that make up the creation unit or sell all or part of them on a stock exchange.

IOPV: Indicative Optimized Portfolio Value

  • The IOPV is designed to give investors a sense of the relationship between a basket of securities that are representative of those owned in the ETF and the share price of the ETF on an intraday basis. Also called Indicative Value (IV).

LMM: Lead Market Maker 

  • A broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security.

NAV: Net Asset Value

  • A mutual fund’s price per share or an ETF’s per-share value.

 

Why Use ETFs

TFs offer a number of potential benefits that can make them extremely effective for helping investors reach specific long-term goals, such as:

  • Wide diversification in a single package. Contrary to much popular opinion, investors benefit from owning more stocks, not fewer. By including all the stocks in an asset class such as U.S. small-cap value, ETFs give that advantage to their shareholders. Studies show that owning more stocks will probably increase your return, and it will certainly reduce your level of risk.
  • Low operating expenses. An ETF has no need to pay a staff of analysts to travel the world looking for exceptional “deals” or to hover over computer screens trying to figure out the economy. ETFs sometimes charge only one-tenth as much as actively managed funds in the same asset class. Those savings go to shareholders.
  • Low internal trading expenses, because they simply don’t trade very often. Portfolio turnover is often overlooked by mutual fund investors, but the combination of commissions and spreads (the difference between bid and ask to buy and sell stocks) can cost as much as a full percentage point per year on top of operating expenses.
  • Because of their lower turnover, ETFs reduce your tax exposure. Sometimes an actively managed fund can hit you with nasty, unexpected tax consequences. For example, a manager may sell a position in a stock the fund has owned for years, leaving shareholders with a large capital gain. In a taxable account, you are liable for your share of that tax even if you owned the fund for only a week.
  • Full Transparency. When you buy an ETF, you know what you’re getting – the performance of an index.  An active manager cannot do anything that easy and simple; he or she must do something different, and hope that it’s better than the index. Unfortunately for shareholders, very often, the opposite is true.
  • Control of your exposure to the specific asset classes you want. In an actively managed fund, there is always the risk that a manager will acquire stocks that may seem attractive even though they don’t fit the fund’s intentions. Index funds also eliminate the risk of duplication, which can leave you owning several funds that all own the same stocks.
  • Investors will most likely get above-average returns. Of course there is no guarantee, but if you buy an ETF and/or index fund and hold it for the long term, your return is likely to be among the top 10% of all returns for funds in that asset class.
  • Less worry about monitoring the performance of an ETF manager. The manager’s only stock-picking role is strictly mechanical, to mirror what’s in the index. This is simple and inexpensive. And it’s very easy to compare your performance with that of its index; they should be extremely close.
  • No or low transaction cost ETFs are easy to rebalance on schedule without worrying whether, by selling, you will miss out on a manager’s “hot streak.”
  • Intraday liquidity or the ability to sell at any time during the day, if required, giving investors more flexibility.
  • ETFs don’t keep your money idle in cash. It is not uncommon for actively managed funds to keep 2% to 10% of their portfolios in cash. One reason is to preserve buying power to purchase “hot” stocks; another is to cover redemptions of shareholders who want to bail out after market declines. That cash can cost shareholders 0.5% a year in return, with no corresponding benefit. This doesn’t happen in index funds.
  • ETFs and Index funds put you in very good company. Index funds are favored by Nobel Prize winning economists, Warren Buffett, John Bogle, Charles Schwab, almost all academics, the largest U.S. pension funds, and almost every fiduciary adviser.

 

 

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