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Exchange Traded Funds (ETFs)

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A New Type of Index Fund Hybrid

[By JD Steinhilber]

ME-PExchange-traded funds (ETFs) are perhaps the most exciting and innovative investment products to be developed by the securities industry in the past 20 years. ETFs, which are essentially index funds that trade on the major exchanges, can enable the physician-investor or financial-advisor to add value to client relationships, by addressing the key issues of diversification, tax efficiency and investment costs.


More formally, ETFs are defined as securities that combine essential elements of individual stocks and index funds. Like stocks, ETFs are traded on the major U.S. stock exchanges and can be bought and sold through any brokerage account at any time during normal trading hours.

Also like index funds, ETFs are pools of securities that seek to replicate the performance of specific market indices, or benchmarks, in a low-cost, tax-efficient manner. ETFs give physician investors the opportunity to buy or sell an interest in an entire portfolio in a single transaction.

In short, ETFs provide the advantages of traditional index mutual funds, including low annual fees, diversification and tax-efficiency, with the liquidity and ease of execution of stocks. 

ETFs trade throughout the day and allow investors to buy and sell them at stated market prices, unlike traditional open-end mutual funds, which are only bought and sold at their net asset value (NAV) determined at the end of each day. ETFs can also be bought on margin and sold short. 

ETFs were developed by large institutions, such as: Barclays Global Investors, State Street Global Advisors and Vanguard.In 2003, approximately $90 billion was invested in U.S. exchange-traded funds; that figure has more than doubled by 2008. 

ETF Asset Classes

ETFs provide exposure to a wide range of asset classes defined by various equity and fixed income indexes. At launch, available ETFs fell into multiple major categories, including:

  • Small-, mid- and large-capitalization
  • Growth, value and core
  • International (broad-based and country- or region-specific)
  • U.S. industry sectors
  • Fixed income

Of course, there are many more tranches or slices today, and for almost any asset class type imaginable. The indexes upon which ETFs are based are from Dow Jones & Company, Inc., Frank Russell Company, Goldman, Sachs & Co., Lehman Brothers, Morgan Stanley Capital International (MSCI), Standard and Poor’s, Cohen & Steers Capital Management, Inc. and the NASDAQ Stock Market, Inc; etc; among many others asset class benchmarks.

Sponsors and Types

The two principal initial sponsors of sector ETFs were State Street Global Advisors and Barclays Global Investors. State Street’s sector ETFs are termed Sector SPDRs (Standard & Poor’s Depositary Receipt), because they are based on the S&P 500. 

The nine original Sector SPDRs collectively encompassed all 500 companies of the S&P 500. Barclays’ iShares sector funds differ from the Sector SPDRs in that they are based on the Dow Jones classification system, which segments the U.S. economy and stock market into 10 sectors encompassing 1,625 companies.

There were iShares ETFs for each of these 10 sectors as well as certain industries, such as biotechnology which are components of broader and/or narrower sectors.  Today, they are almost TNTC.


Continuous information about sector and industry ETFs is available at www.ishares.com.  Information about Sector SPDR ETFs is available at www.spdrindex.com.


Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

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8 Responses

  1. Here is another link, on ETFs, from the WSJ with a nice historical review:


    PS: Congratulations for being syndicated and picked up by the Wall Street Journal.


  2. Lessons Learned In The Exchange-Traded Fund Graveyard

    While ETF closures can be an inconvenience for investors in the short-term, in the long run they are healthy for the industry and investors.




  3. Health Care ETFs?
    [Four Things To Consider]

    The health care industry has been one of the fastest growing segments in the market. But, what is the appeal?


    The Hidden Costs of ETF Investing

    And, although ETFs are generally cheaper than mutual funds, physician investors shouldn’t ignore the fees associated with these vehicles.


    Dr. Lee


  4. Got a great investing idea?
    [Start your own ETF]

    A new online broker allows you to create theme-based baskets of stocks.


    And, if other users like your idea enough to buy into it, you’ll receive royalties.



  5. Bill Gross leaves PIMCO for Janus

    Did you know that Bill Gross, one of the bond market’s most renowned investors, is leaving PIMCO, the investment firm he founded and with which his name has been effectively synonymous, for rival asset management firm Janus Capital Group? .


    Was there an ETF scandal over there?



  6. The investor return/behavior gap

    I am often bewildered that what passes for analysis is really a focus on recent performance, rather than process. Yet, so little attention is given to the investor return/behavior gap, a well-documented phenomenon that proves that “on, average, investors sacrifice a substantial portion of their returns by incorrectly timing when to enter or exit investments”.


    Incorrect timing tends to come from chasing performance, getting in after a major up move has already taken place, and then, of course, exiting when the drawdown is likely near its end. The below chart sums up some of the research on this which, in my opinion, is a “must know” when considering where to put money to work.

    The best returns in the future come from those parts of the marketplace that have not done well in the past. Yet despite the overwhelming evidence which supports this, strong recent performance is often the core catalyst to make an investment. In reality, it should be the exact opposite.

    High past performance and continuous visibility of that performance is a temptation too strong for many to ignore, and that temptation unequivocally results in sub-optimal returns going forward on average. Take that truism on mutual funds, and magnify it by a billion when it comes to Exchange Traded Funds (ETFs). Yes folks – I would argue to you that ETFs are the greatest danger to investors. Why? Because ETFs provide an even greater temptation to chase recent performance, day by day, hour by hour, and minute by minute. Overtrading is the ultimate source of the investor return gap, and the temptation to get “in and out” of the market has never been higher thanks to these investment vehicles.

    Now, don’t get me wrong here. We ourselves use ETFs to execute across our quantitative strategies in mutual funds and sub-advised separate account strategies we run. However, following a systematic, backtested, and quantitative approach using ETFs as the vehicle of choice for execution is NOT what the vast majority of ETFs “investors” do. The pattern of behavior remains the same. Assets for ETFs grow when the ETF has strong recent performance, and collapse after, with a lag, when losses have already occurred. In our case, we rotate based on leading indicators of volatility (click here to learn more). The majority rotate based on old leaders that have had continuously low volatility.

    The greatest danger is in using past strong performance to make an investment decision. ETFs may be the greatest temptation of all that results in exactly that.

    Michael A. Gayed CFA
    [Portfolio Manager]


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