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Exchange Traded Funds are designed to bring diversity

The first Exchange Traded Fund (ETF) in the US was spawned in 1993, the Standard and Poor’s Depositary Receipts or “Spiders”, and was designed to track the S&P 500 index. The fund subsequently became the largest ETF in the world and there are now thousands of ETFs worldwide available on most major exchanges.

An ETF is a security or fund, traded on a stock exchange, that generally tracks an index. As they have evolved and proliferated, ETFs can also track commodities such as gold and oil, bonds, currencies, and now less popularly available in actively-traded versions, in this case not tracking an index but leaving the portfolio selection up to an investment manager.

In their nascent stage, ETFs first tracked major stock indexes such as the Dow Jones Industrial Average and the NASDAQ. ETFs have become so broad in their coverage that they have now created their own indexes, and are structured as sector, geography, and even leveraged and inverse (short) funds. Therefore, given the widespread coverage of asset classes, international markets, and specific sectors, ETFs, like mutual funds, offer the all-important investor objective of diversification.

There is an on-going debate as to whether ETFs or Mutual Funds are more efficient. It can firstly be said that any index structured product, especially those designed to track a major index or benchmark, require little intellectual capital from an investment manager, thus investment management fees for the product would be minimal. This is generally true for both Index Mutual Funds and ETFs. Traditional Mutual Funds are priced daily at the Net Asset Value, and purchases and redemptions by an investor will trade at this price, there is no capacity to trade during the day at different market prices.

ETFs are traded on a stock exchange and can be traded at any time during trading hours at current market prices. As ETFs are generally mirroring an index, the price is strongly correlated to the value of the index, with little room for a premium or discount which may occur during periods of market turbulence. These variations are usually less than a half of a percent. As they trade like stocks, ETFS can be bought on margin, sold short, traded using stop and limit orders, and hedged.

Mutual Funds may have minimum investments which may be prohibitive for the small investors, especially those seeking broad diversification through multiple funds. ETFs can be purchased and sold just like stocks, with as little as a few or even one share. Mutual Funds can be more expense, with fees such as distribution charges known as loads and management fees paid to the fund’s advisors for managing the portfolio. ETFs generally have much smaller annual expenses, ranging an average from 0.1 to 0.65 percent, compared to mutual funds which average 0.1 to 3 percent.

A favoured investment strategy is Dollar Cost Averaging, purchasing a set dollar amount of a security on a regular schedule. This technique is designed to reduce market risk by slowly buying smaller amounts over longer periods of time, instead of all at once at one time. There are Mutual Funds which charge low or no fees for regular investment and these would be more cost competitive than ETFs for this strategy, as ETFs typically have a brokerage fee.

In the quest for diversification, ETFs have proven to be an extremely popular means to achieve this goal, given the widespread availability of investment choices, low costs, correlation to indexes, and ability to trade on an exchange at the market.

Anthony Galliano is the chief executive officer at Cambodian Investment Management.
anthonygalliano@covenantim.com

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