ETFs Versus Mutual Funds

by wadecook

ETFs—Exchange Traded Funds

This investment strategy came on the market back in the late 90s. It has now garnered billions and billions of dollars into its funds. It started with the SPDRs, or Spiders—standing for Standard and Poor’s Depository Receipts, and there were three main ETFs (SPY, MDY and the Qs, QQQ) set up for a short time. Then their popularity exploded. Now ETFs are as popular as Mutual Funds.

An ETF is an Exchange Traded Fund. That name also evolved. This investment animal is actually a Trust which raises millions, even billions of dollars, and goes into the marketplace and buys stocks, usually with a theme. For example, the SPY (Ticker Symbol) is a collection of the S & P 500. The Qs, also called the power shares, is an actual grouping of the NASDAQ stocks—the power 100. In short this is a way for investors to diversify.

But that is what we heard about Mutual Funds. So what is the difference? I should write what are the differences? That is the meme of this section. Like a Mutual Fund these ETF funds own stocks or debt (ETNs). These are not indices, like so many people use for straight trades. An Index is a fictitious collection of stocks without ownership.

I’ll list here many variations, written from a trading viewpoint, of ETFs and Mutual Funds.

OPEN FOR TRADING: ETFs trade like stocks. They are traded on an exchange, and trade when the market is open. Mutual Funds are traded after the market is closed.

VALUATIONS: ETFs are a Trust set up to own stocks and other investments, though most of them just own stocks. The value/price of a share of stock in an ETF changes throughout the day—as the component stocks rise and fall. A Mutual Funds valuation is calculated ones a day when the market is closed and stocks have discounted trading.

LIKE A STOCK: It’s easy to say that ETFs trade like stocks, but think of it—they are stocks. You indirectly own the shares in the trust. For example, the DIAs are very popular. The Dow Jones Industrial Average for years wouldn’t allow any Mutual Funds to only own or mimic the Dow 30. I think the DJIA 30 is the most followed collection of stocks in the world. In fact, when people refer to the American market being up or down, they’re usually referring to the Dow. Along comes ETFs and the S & P is allowed to own just this grouping of 30 stocks. At first they were called the Diamonds, after DIA. They took out the J, and some people still refer to this group as the Diamonds, though that name is vanishing. They’re now just DIA, or the Dow Spider.

DIA: This stock trades at 1/100 of the Dow. If the Dow is at 16,450, this stock will be around $165.46. Allow for a few pennies of difference. Think this through. If the Dow goes up 100 points, the DIAs go up about $1.

TRADING NOTE: We trade the whole market frequently. We call it rolling the Dow. Throughout the years the Dow 30 forms rolling patterns. We trade options for this type of trade. See the “Rolling the Dow” section. While there is not a penny for penny correlation, we’ve noticed when the Dow goes up 100 points the options (leveraged at a fraction of the cost) goes up 50¢.

OPTIONS: So I may as well bring up options. There are no options on Mutual Funds. ETFs however trade like stocks, and therefore have options—calls and puts, meaning all of their uses.

  1. Straight Options. You can buy and sell calls and puts. They have regular expiration dates (like the 3rd Friday) and now many have weekly options. Not all ETFs have options.
  2. You can Write Covered Calls. You can buy the stock of an ETF and sell to someone the right to buy your stock. These premiums are not that high, as the group of stocks will have less volatility than a single stock within its collection. If you think you may want to Write Covered Calls now or in the future, make sure you buy them in 100 share lots.
  3. This is the same argument for diversification: There is safety in numbers.
  4. You can do spreads: Bull Call Spreads, and Bull Put Spreads, to name two out of the four types of spreads.
  5. You can buy and sell options with short-term expiration dates or with a long-term horizon.

VARIETY: Like Mutual Funds you can choose how you want to invest and where. Let’s say you like India, or Europe, you can zero in on Funds that specialize in those geographic regions. You can also chose an industry, like Manufacturing, or High-Tech. And now you can diversify by owning stock in an ETF that owns stocks in other ETFs. That’s not meant as a joke, but it is a bit humorous. I remember the day when Mutual Funds came into existence—ostensibly to help people who don’t like to choose. Now there seems to be more Mutual Funds, and now ETFs than there are stocks.

DIVIDENDS: Dividends have become very popular with many investors as their need for income increases. Mutual Funds collect the Dividends from the companies/stocks they own and add them to the asset base. The accounting (read that tax) is done differently. Read their Prospectus to see how their Dividends are treated.

With ETFs there are two ways, and again you can ascertain this before you invest. One is that the Dividends are held in Trust and then used to buy more stock at certain times. This should increase the value of your stock. The other way is that the Dividends received from the companies are held for a short time and then distributed. It’s kinda cool. Your account may end up with a whole lot of $1.43, $3.90 and $5.22 deposits. It’s just cash. You can use it for whatever you like. One advantage is that you learn which companies actually pay dividends. See the DRIPS section.

If you like Dividends you may want to look at SDY. The D stands for Dividends. This is an ETF (SPDR) which has taken 500 out of 1,500 stocks in the S & P, which have raised their Dividends at least for 25 years in a row.

One note of importance. The DIA pays a Dividend yield of about 2.5%. If you have investments making less than this, meet with you Financial Advisor and see how you can re-allocate your investments.

You should look seriously at how these dividends affect you trading goals. Adjust your trading strategies wisely and prudently.

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