Exchange Traded Funds (ETFs) represent the emerging alternative investment tool to traditional mutual funds. ETFs are indexed mutual funds that trade exactly like stocks, and depending on the specific ETF, can replicate an index in order to provide the broad diversification of a mutual fund without the potential baggage of deferred sales charges. Like all other individual stocks, ETFs are listed on stock exchanges rather than being sold by mutual fund companies or mutual find brokers.
Contrary to popular belief, ETFs are not a U.S. invention. Launched in 1991 on the Toronto Stock Exchange, the TIPS 35, a precursor of today's i60, was the first successful ETF in the world and remains the most widely held ETF in Canada. The first U.S. ETF, an S&P 500-index fund, began trading on the American Stock Exchange in January 1993.
For ETF assets under management in Canada, the past decade has been marked by a compound annual growth rate in excess of 25 percent. Indeed, the number of ETF listings on the Toronto Stock Exchange has almost doubled since 2010. As of August 2013, the past 12 months saw assets of all exchange traded funds increase by $250.51 billion, or 20.6 percent. In the U.S., domestic equity ETF assets increased by $174.51 billion since August 2012, whereas global equity ETF assets rose $63.54 billion. Finally, ICI also reports that assets of bond funds totalled $241.22 billion and hybrid funds equalled $1.32 billion.
Instant Portfolio Diversification ETFs carry instant exposure to a diversified portfolio of stocks resulting in a risk profile that is vastly superior to trading/holding individual stocks. ETFs track the holdings of a stated index, such as the Nasdaq 100 or S&P 500. For example, QQQ shares serve as a proxy for the Nasdaq 100, and by purchasing a single QQQ share, the investor buys the entire Nasdaq 100, instantly holding 100 companies across major industry groups including computer hardware and software, telecommunications, retail/wholesale trade and biotechnology.
Lower Fees As management expense ratios (MERs) for actively managed funds continue to escalate, ETFs remain the leading alternative as very little active management is required when simply tracking a given index. According to Standard & Poor's, the typical U.S. equity ETF costs just 0.4% of assets annually, although some annual fees are as low as .09%-a significant value when compared to the average mutual fund fees of 1.4%. In Canada, the average equity fund has an MER of around 2.4%, while Canada's most popular ETF, the i60 Fund carries an MER of 0.17%. This 2.33% difference means that the average equity fund must outperform the S&P/TSX 60 Index that the i60 mirrors by this amount to give investors the same net return. Over the long term, this is something the vast majority of conventional mutual funds have failed to do.
Lower Capital Gains Taxes Unlike mutual funds, ETFs are tax efficient because the stocks within them seldom change and their underlying structure ensures that holders rarely if ever get penalized with a capital-gains distribution. Investors who want to liquidate shares in an ETF simply sell them to other investors exactly as they would with their individual stocks.
Trading Power A discount brokerage margin account that also includes shorting capability is all that is required: ETFs are priced and traded on stock exchanges throughout the day, and are not restricted to once-a-day trading at the end of the day. Unlike mutual funds, investors can easily obtain up-to-the-minute share prices, either directly themselves or from their broker or financial adviser. ETFs can be bought and sold at intraday market prices, purchased on margin, sold short, and/or traded using stop orders and limit orders, which allow investors to specify their trading price. There are no redemption fees—only standard brokerage commissions apply. Most ETFs also have listed option contracts allowing for even greater leverage or hedging flexibility.
QQQ Shares of Nasdaq-listed QQQ (PowerShares QQQ) represent a portfolio of the 100 largest Nasdaq nonfinancial stocks weighted according to their market capitalization. As the most popular ETF, average daily volume typically far exceeds household names such as Microsoft, Cisco etc. Given their lower per share price point, QQQ shares constitute our recommended trading vehicle for private retail investors.
IWM and SPY Additional recommendations for professional investors include two other Amex-listed stocks whose respective ticker symbols are IWM and SPY. IWM (iShares:Russ 2000 Idx) represents the industry benchmark for mid- and small-cap companies, tracking the performance of 2000 firms. SPY (Standard & Poor's Depositary Receipts or SPDRs) shares represent a portfolio of equity securities that comprise the S&P 500's Composite Stock Price Index and are presently the second most popular ETF in the U.S. Both ETFs are highly liquid trading vehicles which adhere to Marketpolygraph's behavioral requirements and although IWM has delivered superior returns relative to SPY in our model portfolio, shares of SPY represent a clear opportunity for further portfolio diversification.
QLD and QID Given Marketpolygraph's extremely high rate of market call accuracy, many investors leverage this capability with two inversely correlated Amex-listed stocks: shares of QLD (ProShares Ultra QQQ ETF) generally double the performance of the QQQ's in a rising market while shares of QID (ProShares UltraShort QQQ ETF) generally double the performance of shorted QQQ's in a declining market—without ever having to go short.
HQU and HQD Both TSX-listed ETFs represent the respective Canadian-denominated versions of the QLD and QID ETFs: shares of HQU (Horizons BetaPro NASDAQ-100® Bull Plus ETF) generally double the performance of the QQQ's in a rising market, while shares of HQD (Horizons BetaPro NASDAQ-100® Bear Plus ETF) generally double the performance of shorted QQQ's in a declining market—without ever having to go short.
TNA and SQQQ Finally, Marketpolygraph will ocassionally deploy the following two inversely correlated leveraged ETFs: shares of TNA (Direxion Daily Small Cap Bull 3X ETF) generally triple the performance of the Russell 2000® Index in a rising market, while shares of SQQQ (ProShares UltraPro Short QQQ ETF) generally triple the performance of shorted QQQ's in a declining market—with once again never having to go short.