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What to know before you invest in exchange-traded assets

Mark Daly
Mark Daly

Exchange-traded products (ETPs) have provided individual investors a level playing field compared to bigger players, allowing almost anyone to participate. Many ETPs have low or no minimum dollar requirements, and in many cases can help provide diversification.

Exchange-traded products are investment products that “derive” their value from a basket of stocks, bonds, indexes or commodities. ETPs trade intraday on a stock exchange, can be tax friendly, and may offer lower expenses than other managed products. There are two common types of ETPs:

Exchange-traded funds (ETFs) offer shares that track an underlying benchmark or index like the Standard & Poor’s 500 U.S. stock index, or Bloomberg Barclays Aggregate Bond Index.

Exchange-traded notes (ETNs) are senior unsecured debt obligations designed to track the total return of an underlying fixed income index, portfolio or benchmark, minus fees and expenses, which ultimately affect performance and returns.

Unlike traditional mutual funds, the purchases and redemptions of other shareholders do not affect ETFs. Traditional open-end mutual funds settle in cash when the fund manager sells a position to meet fund redemptions, often creating a capital gain that gets passed along to remaining shareholders.

ETFs are created and redeemed through in-kind transfers with other large institutional investors, often preventing capital gains from occurring.

Aggressive marketing and product proliferation imply these products are nearly “free,” but investors may incur trading costs, internal management expenses and the possibility of taxable year-end distributions. Product sponsors often create esoteric “specialty” funds that don’t belong in most portfolios.

Access to ETPs can be beneficial for investors depending on their specific needs, and since trading occurs throughout the day, price and internal holdings are fully disclosed.

How much value does any product offer compared to placing greater emphasis on planning and behavior – the age-old dilemma of product versus process? Experience has shown that most successful investing is goal oriented and planning driven, while most unsuccessful investing is market focused, product driven and performance centric.

October’s dismal results just ended may provide an opportunity to add to existing investments at lower prices, rebalance existing investments, and replace underperforming managers, regardless of the type of product used.

The addition of ETPs may offer ease when assembling a broadly diversified portfolio, but only after investment objectives, risk tolerance, time horizon and written goals are considered.

Mark Daly is an investment mangement analyst and a partner in The Perpetua Group. Mark@theperpetuagroup.com.

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