Are exchange-traded funds better than mutual funds?

July 1, 2010

Investing in an ETF provides investors with the ability to invest in index-type portfolios that replicate the returns of many widely known indexes.

Key Points

Investing in an ETF provides investors with the ability to invest in index-type portfolios that replicate the returns of many widely known indexes. SPDRs (Spiders) track the S&P 500 index, while the QQQQ tracks the NASDAQ-100 Index. Other ETFs focus on a specific global geographic region, commodities, or even specific industry sectors. The popularity of ETFs has increased dramatically since their introduction in 1993, and while much of the growth is attributable to institutional investors, individuals have played a significant role as well.

Tax efficiency is provided through the index focus of ETFs. Because they are not actively managed, securities are only bought or sold based on changes in the underlying index being replicated, which is the same as with passively managed index mutual funds. Index funds, whether purchased via an ETF or a mutual fund, generally are more tax efficient than mutual funds, the managers of which make many changes in the portfolio, causing an income tax liability to be passed through to shareholders.

While ETFs can provide certain advantages, investors should realize that, unlike regular mutual funds, their pricing in the market is subject to supply and demand of the issued shares. Although the price of the ETF is closely tied to the value of the underlying index securities, prices may be at a premium or a discount to the actual net asset value of the portfolio. This differs from open-end mutual funds, where the daily price is exactly that of the underlying assets. Despite gaining investors' attention, ETFs are not for everyone and remain best suited for those who would like to invest in index funds but want the same active trading scenario as stocks.

Q How does the strength or weakness of the U.S. dollar impact foreign investments?

A Exchange rates essentially represent the cost of one country's currency in terms of another's. Changes in exchange rates are driven by a complicated mix of factors, including inflation, interest rates, and a country's economic growth. The mechanism that causes the changes is the theory of supply and demand. Demand for a country's currency can fluctuate based on the anticipated relative strength of the currency. The greater the perceived strength, the greater the likelihood of increasing demand. When demand for a country's currency from outside buyers is greater than the available supply, the price of the currency increases, and when supply exceeds demand, the price of the currency decreases. The fluctuation in currency exchange rates is often classified as "currency risk."

As an example, let's assume you own a company located in a foreign country. If the U.S. dollar rises in value relative to the currency of the country where your company is located, the value of your investment declines as measured using the U.S. dollar. A weakening U.S. dollar, on the other hand, would increase the value in the foreign investment as measured in U.S. dollars. Of course, there will also be fluctuations in the price of the security itself based on a variety of other factors, such as earnings growth, market expectations, and demand.

Money Matters

Joel M. Blau, CFP, Ronald J. Paprocki, JD, CFP, CHBCJoel M. Blau, CFP, (top) is president and Ronald J. Paprocki, JD, CFP, CHBC, is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago. They can be reached at 800-883-8555 or blau@mediqus.com
or paprocki@mediqus.com
.