Tuesday, November 29, 2011

Frush, All About Exchange-Traded Funds

ETFs have been a major force in the markets for some years. It is perhaps a tribute to their success that a subcommittee of the Senate Banking Committee held a special hearing last month examining such topics as whether ETFs are contributing to volatility and posing risks to the financial system.

Scott Paul Frush writes for those who want, as the subtitle of every “All About” book reads, “the easy way to get started” in ETFs. All About Exchange-Traded Funds (McGraw-Hill, 2012) is a comprehensive introduction. Among other things it includes a brief history of ETFs, it identifies the players, it explains how ETFs come to market, it describes their internal workings, and in a hundred-page section it outlines the main types of ETFs (broad-based, sector and industry, fixed-income, global, real asset, and specialty). It even includes a list of ETF closures by year, through 2010.

In an early chapter Frush discusses the advantages and drawbacks of ETFs over mutual funds and individual stocks. Let me mention just three here. First, a plus for ETFs, they are not subject to style drift, “the tendency of a portfolio manager to deviate from his or her fund’s specific strategy or objective.” (p. 44)

Second, a plus for mutual funds, some ETFs suffer from dividend drag, “the implicit cost some ETFs incur as a result of the … SEC rules stipulating that certain ETFs cannot immediately reinvest back into the portfolio the dividends paid by companies held in the fund. Instead, some ETFs must accumulate the dividends in a cash reserve account and pay them to shareholders at periodic intervals—typically quarterly. This requirement differs for mutual funds, as they can reinvest dividends immediately.” (p. 45)

Third, ETFs are fully invested by nature—“and that’s a very good thing for investors.” Mutual funds, by contrast, must allocate part of their holdings to cash to satisfy shareholder liquidations. “If you were to build a portfolio of 60 percent equities and 40 percent fixed income and later discovered that many of your equity mutual funds hold 10 percent cash, you might not be too happy since that means that your actual portfolio allocation is closer to 54/46 percent equities to fixed income, respectively.” (pp. 46-47) Speaking of asset allocation, Frush devotes a chapter to the topic in the final part of the book on how to use ETFs.

All About Exchange-Traded Funds is a well-written, balanced introduction. Both individual investors and financial advisers could profit from reading it.

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