Bearing some resemblance to mutual funds, the ETF is actually in a class of its own. Rather than purchasing an individual stock, an ETF is a manner of automatic diversification, without the capital demands of individual stock purchase, yet all the while allowing the benefits of direct stock appreciation.
Mutual funds will have a daily valuation that will apply to all transactions on that day, as the unit price is altered to reflect the funds asset value; the advantage to the short term trader is minimized. ETF’s on the other hand are quite able to be traded intra-day, as the price will dynamically respond to the ordinary markets forces of demand and supply, and are able to trade at a discount or a premium to the underlying instrument they are hinged upon. This of course will take into account numerous fundamental variables, not the least of which is the cash and carry premium that is inherent in synthetics to reflect the absence of physically carrying the underlying instrument or commodity. Importantly, short selling is possible with ETF’s, and so trading on margin also adds to the inherent leverage that this type of synthetic instrument allows.
ETFs are available on numerous underlying instruments including indices, industry sectors, regional sectors, commodities, and in fact a plethora of niche markets that marvelously, even extend to fixed interest income streams. In a bid to maximize every possible return, this type of flexibility allows investors to tailor their portfolios to unprecedented accuracy. With ETF’s, any composition is quickly able to be implemented and adjusted when the need arises.
Often a mutual fund will charge fees up to 3% p.a. while an ETF will rarely exceed 1%. Still given a liquid ETF market exists, the bid ask spread will contribute to an investors expense and will detract from any return accruing. This is the one aspect of ETF trading that may dissuade smaller investors from redirecting investments from similar leveraged instruments such as mutual funds. Larger institutional traders on the other hand can cover their exposures easily in large volumes, which are far easier to execute than in individual markets.
There also exists a certain tax advantage concomitant to ETF’s. Capital gain will be realized and tax will accrue upon the conversion of equity through an exit trade. Additionally, some ETF’s upon equity will allow an exchange for physical stock, and similarly enabling the deferral of tax. Mutual funds however, must purchase and redeem shares of stocks as they are created within the fund, and then distribute the capital gain each quarter. This declaration is subject to an immediate tax liability, a nuance that an ETF does not lend itself to.