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Personal Wealth: Is an Exchange-Traded Fund Right for Your Portfolio?
Exchange-traded funds have been around for years, but new offerings have increased their profile even more.
ETFs are baskets of securities that are traded, like individual stocks, on an exchange. Anything you might do with a stock, you can do with an ETF.
Unlike mutual funds, ETFs can be bought and sold throughout the trading day. As with stocks, you must pay a commission to buy and sell ETF shares, which can be a significant drawback for those who trade frequently or invest regular sums of money. However, most charge lower annual expenses than even the least costly mutual funds.
Although ETFs are more flexible than mutual funds in many ways, their shares cannot be bought from or sold back to the fund company like regular funds. Instead, individual investors trade ETF shares over an exchange.
Only very large institutional investors buy or redeem shares directly from the fund company in 50,000-share blocks. Those large transactions are carried out "in kind." That is, the big investors don't get cash when they redeem shares, they get the underlying stocks.
The same process works in reverse for purchases. Big investors assemble a portfolio of stocks (in the same proportion that they are held in the ETF) and deliver it to the ETF provider, who then hands over new ETF shares.
Unlike regular funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, the market price of an ETF is determined by forces of supply and demand for the ETF shares, which to a large extent is driven by the underlying values of their portfolios, but other factors can and do affect their market prices.
However, by permitting large investors to buy or redeem shares in kind, the fund companies behind ETFs have created a mechanism that should, in theory, help prevent sustained discounts or premiums from opening up.
ETFs have several clear advantages over traditional funds: lower annual expense ratios, greater tax efficiency and flexible trading. Nevertheless, they aren't suitable for everyone. Investment research firm Morningstar Inc. publishes research and commentary about ETFs for individual investors, available at www.morningstar.com.
A detailed look at the advantages and disadvantages of ETFs will help you decide if they are the right investment for your portfolio.
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