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Exchange Traded Funds
Article Summary: Exchange Traded Funds allow investors to trade index portfolios just as they do shares of stock. Exchange Traded Funds can be traded throughout the day unlike open-ended mutual funds which can be traded only at the end of the day when net asset value is calculated. Moreover, the Exchange Traded Funds can be sold short or purchased on margin.
Exchange Traded Funds allow investors to trade index portfolios just as they do shares of stock. Exchange Traded Funds can be traded throughout the day unlike open-ended mutual funds which can be traded only at the end of the day when net asset value is calculated. Moreover, the Exchange Traded Funds can be sold short or purchased on margin.
Exchange Traded Funds also offer potential tax advantage over mutual funds. The capital gains tax that results when the fund sells securities to meet the redemptions made by investors are passed through to the remaining investors of the mutual fund. In case of Exchange Traded Funds, investors sell their shares to other investors. Therefore the fund need not sell securities. Hence there will be no capital gains tax incurred by the fund.
Large investors have the ability to redeem Exchange Traded Funds for a portfolio of stocks comprising the index or exchange a portfolio of stocks for shares in the corresponding Exchange Traded Funds. This ensures that the price of an Exchange Traded fund will be close to the net asset value of that portfolio. Any meaningful discrepancy would offer arbitrage opportunities for these large traders, which would quickly eliminate disparity.
Exchange Traded Funds are also cheaper than mutual funds. Investors who buy Exchange Traded Funds do so through brokers rather than buying directly from the fund. Therefore, the fund saves the cost of marketing itself directly to small investors. This reduction in expenses results in lower management fees.
There are some disadvantages to Exchange Traded Funds, however.
1. Because they trade as securities, there is the possibility that their prices can depart by small amounts from net asset value. As noted, this discrepancy cannot be too large without giving rise to arbitrage opportunities for large traders, but even small discrepancies can easily swamp the cost advantage of Exchange Traded Funds over mutual funds.
2. While mutual funds can be bought at no expense from no-load funds, Exchange Traded Funds must be purchased from brokers for a fee.
Cost of Investing in Mutual Funds
Front-End Load
A front-end load is the commission or sales charge paid to the broker when units of Mutual Funds are purchased. Different funds charge differently to collect this. If no front-end load is collected then the Asset Management Company can collect additional management fee every year.
Back-End Load
A back-end load is the fee collected by the Mutual Fund during redemption of units by the investor. This is otherwise known as “exit fee”. These charges are more formally known as Contingent Deferred Sales Charges (CDSC). Many funds start back-end loads at 5% or 6% and reduce them by 1% every year the investor holds the units.
Operating Expenses
Operating expenses include administrative charges and advisory fees paid to the Asset Management Company. These charges are expressed as a percentage of the total Assets Under Management (AUM). Usually these charges range from 0.1% to 2.5% of the assets under management. Operating expenses are not incurred explicitly by the investors. It comes as the reduced value of the portfolio.
12b-1 charges
Some of the funds (the so-called 12b-1 funds) can pay their commissions to brokers and other distribution expenses like advertising and preparing promotional literatures from the fund assets. The “12b-1 fees” is named after the rule of the Securities and Exchanges Commission (SEC) that allows these funds to do this. These charges, like the operating expenses, are not incurred directly by the investor. The maximum amount that a fund can use for 12-1 charges is limited to 1% of the average net assets per year.
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About the Author:
Dilip Mohan
For more information about exchange traded funds visit http://www.mutualfundforu.com/exchange_traded_funds.html">Exchange Traded Funds and to know about investing in mutual funds visit Investing in Mutual Funds
