Latest news, trends and ideas for investing with exchange traded funds | ETF Commentary

The severe bear market is providing investors a rare opportunity to remake their portfolios while incurring little or no capital gains taxes.

In the article It’s a Great Time for a Makeover, New York Times contributor Paul Lim relays advice from financial planners that now is the time for investors to think about overhauling their portfolios. The current bear market has wiped out gains from the past 10 years leaving many people in a position where they would have little or no taxes to pay from selling existing holdings.

In particular, advisors are recommending to diversify portfolios while lowering expenses. Foreign stocks and real estate had been relatively expensive before the markets began their slide. Now foreign stocks trade at a P/E of 10, down from 14 in 2007. Real estate investment trusts or REITs are down 40%.

Investors can lower expenses by shifting out of stocks, bonds and mutual funds and into exchange traded funds. ETFs offer instant diversification at a much lower cost than the typical actively managed mutual fund. Lim suggests looking at iShares S&P 500 (IVV) , an ETF with an expense ratio of 0.09%.

ETFs that offer exposure to REITs include the FTSE NAREIT Industrial/Office Index Fund (FIO) and Cohen & Steers Realty Majors (ICF). For more on real estate, see Investing in REITs with ETFs.

ETFs that provide broad access to foreign stocks include the MSCI EAFE Index Fund (EFA) and Vanguard FTSE All-World ex-US ETF (VEU). For a complete listing, see the International ETF Directory.

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Ian Salisbury reviews the lessons learned from investing with exchange traded funds in the WSJ article The Tricks of the ETF Trade.

Salisbury points out that investors need to look at things like volume, bid-ask spreads, premiums-discounts, indicative intraday value (IIV), limit vs. market orders and trading time of day.

For example, Salisburby notes that amid the bond-market turmoil in October, iShares Lehman Aggregate Bond Fund (AGG), a broad, supposedly liquid ETF that tracks the whole bond market, closed 8.9% below the value of its holdings one day.

Another example is in the case where heavy volume benefits small investors. Comparing State Street’s SPDR S&P 500 ETF (SPY) with the iShares S&P 500 Index Fund (IVV), Salisbury writes that with the SPDR fund, which trades about 435 million shares a day, investors pay a spread of about a penny a share. With the iShares fund, which trades about eight million shares a day, trading costs are closer to two cents.

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CNBC reported this morning that holders of Auction Rate Preferred securities (see Nuveen’s ETFConnect.com for a good overview) were having problems getting their money out of their investments. In the investing world, the ability to get your money out of an investment is called liquidity.

Since ETFs are a way to invest, liquidity is an important consideration. Is ETF liquidity a major consideration? What determines ETF liquidity? To answer that question, you should understand what an ETF is and where ETF shares come from.

The vast majority of money in ETFs are in funds that track a major equity index (a group of stocks) by actually buying shares of the companies that are in the index. Most ETFs are open-ended, that means that there is no fixed number of shares. As money comes into an ETF, the market maker simply creates new shares and then invests the money into the shares of the companies that make up the index.

The same is true for when money flows out of an ETF – the market maker will sell the shares of the underlying companies and eliminate the appropriate number of ETF shares.

So the ability to put money in or take money out of an ETF, the ETF’s liquidity, is not determined by the number of ETF shares that are traded in any one day. Liquidity is a function of how easy it is for the market maker to buy or sell the ETF’s underlying securities.

ETFs that track the indices of the largest and most actively traded public companies will be the most liquid. Examples include State Street’s SPDR S&P 500 ETF (Amex: SPY) and Dow Diamonds (Amex: DIA), PowerShares’ QQQ (Amex: QQQQ), and Barclay’s iShares S&P 500 Index Fund (Amex: IVV).

ETFs that track indices of equities with lower trading volumes will be less liquid by definition. We’ll cover those ETFs as well as ETFs tied to other securities in ETF Academy: ETF Liquidity Part 2.

To learn more about the technical underpinnings and empirical evidence on ETF liquidity, we recommend an article by Salomon Smith Barney’s Kevin McNally “The Truths About ETF Liquidity and Pricing“.

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