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This a transcription of the Mullooly Asset Management podcast from October 3, 2012.

Brendan: Hello and welcome to the Mullooly Asset Management podcast for October 3rd, 2012. This is Brendan and today we’re going to be speaking with Tom Mullooly of Mullooly Asset Management about Exchange Traded Funds.

Tom, can you tell us what an Exchange Traded Fund or ETF is?

Tom: An Exchange Traded Fund, Brendan, is a basket of investments and they’re usually a basket of stocks that are traded on a stock exchange.

Brendan: Aren’t all investments traded on an exchange somewhere? Why is the fact that an ETF trades on a stock exchange important?

Tom: Well, most people think all investments trade on an exchange somewhere, but they don’t trade on an exchange. Like, for instance, government bonds don’t trade on an exchange, tax free municipal bonds, they don’t trade on an exchange. Mutual funds, which invest in stocks, they don’t actually trade on an exchange, they technically trade over the counter and their price is set once per day, and that’s really an important distinction.

Brendan: All right. You kind of lost me there, can we walk through this again?

Tom: Sure. To best explain what an Exchange Traded Fund is, let me first explain what a mutual fund is. Mutual funds, like Exchange Traded Funds, are a basket of investments. Usually stocks, but sometimes bonds and commodities. When you invest in a mutual fund, you’re usually investing in terms of dollars, not shares. And the reason for that is, because we never know precisely what price we’re going to get, so we say, “Okay, let’s put $10,000 into this mutual fund,” we don’t say, “Let’s buy 217 shares of that mutual funds,” we think in dollar terms with mutual funds.

You get the closing price of the fund on the day that you buy it, so the price gets set after the stock market closes for the day. And likewise, when it becomes time to sell that mutual fund, it’s never really a question of price, it’s hard to say, “Hey, sell that thing when it gets to $22 a share.” That’s not really how mutual funds work. Just when it’s time to sell it, we just sell it.

Because just like when we buy a mutual fund, we never know the price we’re buying at and we never really know the price we’re selling at until the day it’s bought or sold.

Brendan: That’s because the price of the mutual fund is set after the stock market closes that day, right?

Tom: That’s absolutely right. See, a mutual fund doesn’t trade on the New York Stock Exchange. The price never changes throughout the trading day. The price of a mutual fund is set after the stock market closes for the day.

Now, on the flip side, Exchange Traded Funds are still a basket of funds, like a mutual fund, but they trade every day on the stock exchange, and the price of that basket is going to go up and down based on how all the things, all the different investments in the basket are doing that day, it trades just like a stock.

Brendan: Okay. I understand. Why is this important though?

Tom: Okay. Well, remember a few moments ago I had said that mutual fund prices are set once per day after the market closes? Now with an Exchange Traded Fund, we can set a limit price, meaning, you know, we can be proactive instead of reactive. We can’t set a limit price with a mutual fund because we never know the precise price we’re going to get. But with an Exchange Traded Fund, or an ETF, we can set a limit to sell if it gets up to a certain price during a day. That’s a very, very big deal.

Likewise, we can also set a stop order underneath the price of the fund, the Exchange Traded Fund. So if an ETF drops below a certain point, we can have a pre-set stop order in place to protect the investment, and you know, we use charts to manage money for our client, so we’ve got a pretty good idea where we want to place that stop if it’s falling during the day.

Brendan: Okay. So what else is important about ETF’s?

Tom: Okay. Well, a mutual fund is only required to report their holdings a couple of times through the year. Some report every quarter, some report every six months, you never really know on a certain day precisely what you’re investing your money with in a mutual fund. You’ve kind of got an idea, but you never know exactly. But with an ETF, we know exactly where the money is invested in.

For example, IYW, that’s the ticker symbol for the I shares technology sector Exchange Traded Fund. At this moment in time, in October 2012, 24.5% of the money in this basket is going into Apple Computer. 8.89% goes into Microsoft. 8.55% in IBM. 7-3/4% of the money in this Exchange Traded Fund is invested in Google. So in IYW’s case, in this Exchange Traded Fund, just about 50% of your money is invested in just 4 stocks, Apple, Microsoft, IBM, and Google.

Brendan: Sounds like a pretty big deal to me . Is there anything else we should know about Exchange Traded Funds?

Tom: Yeah, well, remember, since they trade like stocks on an exchange, ETF’s are going to have commissions, just like a stock would.

Brendan: Why would paying a commission be a good thing?

Tom: There are some times where paying a commission really is a good thing. See, there are some discount brokerage firms that offer some commission-free trades on certain ETF’s. And buying an Exchange Traded Fund with a discount broker can be way cheaper than investing in a mutual fund.

Brendan: How’s that?

Tom: Well, built into the price of a lot of mutual funds are expenses. Some mutual funds carry a built-in sales charge, it’s called a sales load.

Brendan: I know there’s also no-load funds though, too, right?

Tom: Yeah, you’re right. And a lot of funds today carry no sales charges, but all funds, whether it’s a mutual fund or an Exchange Traded Fund, all funds carry expense charges. And that can be charges for anything up to and including paying the mutual fund manager, paying for trading costs, paying for advertising expenses.

Brendan: Okay. So Exchange Traded Funds don’t have these expenses then?

Tom: Well, they do have these expenses, but, some of them, but not all of them. For example, there’s a lot of ETF’s that track an index, like the S&P 500 index. There’s really no need for a portfolio manager there because that Exchange Traded Fund is just tracking an index. So the expenses for an Exchange Traded Fund are oftentimes a lot less than a mutual fund, but not always.

But like any investment, you have to do your homework first before you invest.

Brendan: All right, Tom. So to sum it up, you like Exchange Traded Funds because they are traded on a listed exchange, you can set stop orders and limits on them, they can get pretty specific in terms of buying a sector or a small basket of companies, and often, but not always, they can carry far less expenses than a mutual fund?

Tom: That’s absolutely correct. You can also invest in some fixed income, you know, some bond Exchange Traded Funds, and you can also invest in Exchange Traded Funds that own things like commodities, too.

There are many, many ways to invest in Exchange Traded Funds now in 2012. There’s several benefits to ETF’s, but this podcast is long enough already, we simply can’t mention everything in one podcast.

All of these benefits of ETF’s are important to know, but they’re not considered investment advice. And this podcast, or any podcast of Mullooly Asset Management, is not a recommendation to buy or sell any of the securities mentioned here.

None of the securities mentioned in this podcast represent a past specific recommendation of Mullooly Asset Management. And if you’re relying on a podcast for investment advice, I need to tell you, you’re making a huge mistake. We strongly urge all of our listeners to consult with their investment advisor before they make a decision to buy or sell any kind of investment. And if you don’t have an investment advisor, feel free to get in touch with us at Mullooly Asset Management. We’ll be happy to answer all of your burning questions about investments and any specific questions you have about a certain mutual fund, a stock, or any other kind of investment.

You can reach us on the web at Mullooly.net, that’s M-u-l-l-o-o-l-y.net, or you can call us at 732-223-9000.

So Brendan, we’ve had some great questions from you about Exchange Traded Funds and we look forward to catching up with everybody next week on the podcast.

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