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Afraid of spiders? If index funds interest you, you shouldn't be.
So-called "spiders," the original exchange-traded fund, work just like index mutual funds but trade like individual stocks. In other words, you can buy and sell shares of them on a major stock exchange while getting exposure to the entire index they track.
The actual term for this type of investment is SPDR, which stands for Standard & Poor's Depository Receipt. There are many types of spiders that follow various S&P indexes, but the first spider, rolled out in 1993, follows the S&P 500® Index.
These spiders obviously give you exposure to the S&P 500, just as if you had bought an S&P 500 index fund, but spiders offer unique features that an index fund cannot.
Spiders versus Index Funds
Investing in an index fund enables investors to buy shares in an entire index in a single transaction instead of buying the individual stocks that comprise it. Index funds are not actively managed like most mutual funds, but simply depend on the up and down movement of the index as a whole. Best of all, index funds tend to outperform actively managed mutual funds.
But there's one problem. Like all mutual funds, index funds are priced only once at the end of every trading day. But prices can change radically in a day, especially in turbulent markets.
Exchange-traded funds, or ETFs, as they're called, are closed-end index funds that let investors take advantage of those daily price movements by trading like a stock. You can even buy them on margin and sell them short.
Spiders provide other advantages over index funds. First, single shares of spiders don't cost as much to invest in as index funds. Each share costs a fraction of the price of the S&P 500, for example. Investors who don't want to pay as much as the minimum investment of S&P 500 index funds can more easily afford spiders that track that index instead.
Second, spiders tend to be more tax efficient and incur lower expenses than index funds. Index funds already have lower management fees than most mutual funds, but spiders have even lower annual expenses.
Investors also get a capital gains tax break from spiders that they can't get from mutual funds. Traditional mutual funds, including index funds, can end up generating year-end capital gains, even if they didn't sell shares. These funds must distribute capital gains that exceed losses to shareholders each year. But spiders generate fewer capital gains because managers do not have to liquidate stock for redemptions. Investors owe capital gains taxes on spiders only when they sell the investment.
Spiders are particularly useful in maintaining consistency in a portfolio. Most investors allocate certain percentages to segments of the market. When certain sectors do better or worse, those percentages can shift away from what the investor originally intended. It's easier and cheaper to rebalance when using exchange-traded funds, such as spiders.
However, since spiders trade like stocks, investors should keep in mind that they must pay brokerage commissions when buying and selling them. For some, these fees can offset the other cost savings that spiders offer.
Other Exchange-Traded Funds (ETFs)
Most ETFs are listed on the American Stock Exchange and they invest in a gamut of indexes from the broad to the specialized. Other major ones include DIAMONDs which track the 30 stocks in the Dow Jones Industrial AverageTM, and "Qubes," which are pegged to the NASDAQ® 100. Other ETFs focus on virtually every niche area tracked by an index, including sectors, such as technology and financials, and foreign stock markets, such as Japan and the UK.
Spiders and other exchange-traded funds aren't for everyone, however. You need to properly assess how you plan to use an ETF before purchasing one. For some investors, ETFs could end up costing you more than a traditional index fund. But for those who like the flexibility and cost-effectiveness of these investments, spiders are nothing to run away from.
S&P 500 is a registered trademark of Standard & Poor's Corporation, a division of The McGraw-Hill Companies, Inc.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.