Exchange Traded Funds

Today I bought my first Exchange Traded Fund (ETF). These are like mutual funds which invest in a bunch of different companies, but ETF’s are sold on the market like a stock with their prices changing throughout the day. For the most part ETF’s reflect some kind of index like the S&P 500 or, in the case of the one I bought, the Nasdaq 100. They are similar to closed-end mutual funds where an investment company would gather a bunch of money and buy a portfolio of stocks and then sell shares on a market. The problem with closed end funds is they usually sold at a discount to the value of the assets in the portfolio because the people running the fund would take out expenses each year and over a long enough period of time the fund would be worth nothing. The price and value could get out of sync by 10% or more.

The ETF’s apparently have fixed that by remaining open-ended. I’m not exactly sure how it all works, but somehow the value of the assets is kept in line with the value of the shares and as they take in more money they buy more assets or sell assets as people sell shares (they use big insurance and pension funds’ holdings as a buffer).

Anyway, the Nadaq 100 shares (symbol QQQ) are one of the biggest ETF’s out there. The real value of them is that you are diversified just like with a mutual fund (I’m investing in the 100 biggest Nasdaq stocks at one time), but also the expense ratios are very low. For instance, the average mutual fund has expenses of 1.27% which they take out of the fund every year. So if you have $1,000 invested they are charging you $12.70 per year (only you never see it). Vanguard 500 Index Fund has one of the lowest expense ratios for any mutual fund, taking only 0.18% a year for the operation of the fund (Vanguard would charge you a fee of $1.80 on $1,000; don’t feel bad for Vanguard that comes out to $141 million for their $78 billion fund). The expense ratio of QQQ is also 0.18% so that is about as low as you can get.

The only bad part is you have to buy ETF’s like a stock so you pay a broker commission on every trade whereas it is free to invest in a no-load mutual fund and easy to reinvest dividends or add small increments every month. Still, that’s not much. But the nice thing is you can sell at any time and you can get price updates throughout the day.

There are other ETF’s too. I had almost decided to buy some Merck about six months ago, but didn’t want to put all of my money into one pharmaceutical company which could be impacted in a big way by a patent running out or a drug being banned (like Vioxx which sent Merck’s shares down 30% in a day). Instead I was looking to invest in PPH which is an ETF investing in pharmaceutical companies. Eventually I decided not to invest because PPH didn’t seem to go up or down that much and stayed in a fairly narrow range. Now that Merck has dropped (which was about a quarter of PPH’s holdings) PPH might be a good buy again. People will always need drugs . . .

Part of the key behind an ETF is to stick to some formula like an index so that there won’t be any question of where additional money goes or which assets are sold if everyone decides to get out at one time. So there don’t seem to be any actively managed ETF’s yet.

It’s always nice to make money the first day and I’m up $10.

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