Aseem Chandawarkar, Ph.D
(This article is reprinted from Monthly Newsletter by FuturOpt. FuturOpt specializes in the development of investment methodologies utilizing quantitative methods and contemporary trading technologies. )
ABCD … ETF
The alphabet soup for the retail investor contains this commonly used acronym – ETF – Exchange Traded Fund. It walks like a stock, it quacks like a stock, it trades like a stock – but it is like a mutual fund!
Unlike a mutual fund that can be purchased or sold at the end of a trading day at its Net Asset Value (NAV) as of that time, an ETF can be traded on the stock market at any time the market is open, just like a stock. Unlike mutual funds, one can trade derivatives on the larger ETFs. So, where is the likeness? It comes from the fact that ETFs are financial instruments created by institutions based on investments in underlying securities. This gives an ETF an inherently lower volatility relative to the constituent stocks and bonds and allows a retail investor to partake in a particular area that the ETF is investing in – an industry sector, a global region, a style of investing, …, any combination
of these. For example, one can trade an Index ETF that tracks a particular index; a regional ETF that tracks a particular world region; a sector ETF that tracks an industry sector. Then, there are growth, income, value, … , ETFs.
One has to be careful, though, to understand the behavior of the ETF relative to whatever it is meant to track. There are leveraged ETFs that respond two-or three-times to the underlying space. Owning these ETFs is like driving a car with an over-sensitive steering wheel – it will turn twice or thrice as much with the same turn of the steering wheel! There are also “short” ETFs that have a negative correlation to the underlying
securities – for example, a short S&P500-based ETF is meant to rise in value when the S&P500 index falls. It is like a car that turns right when the steering wheel is turned left, and vice versa. Not that such a car cannot be driven, or driven to the driver’s advantage. It just requires a particular skill and practice to drive such a car without incident!
Several ETFs pay out dividends (called distributions) on a regular basis – some of them on a monthly basis. There are some ETFs that have regularly yielded high dividends.
So, what do I look for when I choose an ETF? I look at the following dimensions:
• The underlying sector. Do I believe in the underlying sector? Do I understand the underlying sector?
• Trading Volume. This represents the liquidity of the ETF, and the ability for an investor to reverse a position within a reasonable range of
the quoted prices.
• The Bid-Ask spread. The smaller the spread, the higher is the chance that one can get a trade near the quoted prices.
• The existence of derivatives. This is of particular interest to my trading activity, but may be a non-issue for other investors.
You may have your own criteria to filter out ETFs of interest from the hundreds that are out there. I welcome your inputs.
As a closing message, this is an investment area not to be ignored, while at the same time, treaded with caution!
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