A Beginner's Guide To Investing In The Dod Etf

Exchange-traded funds (ETFs) are an easy way to begin investing. ETFs are fairly simple to understand and can generate impressive returns without much expense or effort. The DOD ETF, or Dogs of the Dow ETN, is an example of an ETF that tracks the Dow Jones High Yield Select 10 Total Return Index. This index is based on an investment strategy that involves investing in the ten DJIA components with the highest dividend yield and rebalancing holdings annually. While the DOD ETF ceased trading in 2019, understanding how it worked can provide insight into how ETFs function and how they can be used as an investment strategy.

Understanding ETF basics

Before investing in an ETF, there are several key concepts to understand. Firstly, ETFs can be classified as either passive or active. Passive ETFs, also known as index funds, aim to track a specific stock index, such as the S&P 500. On the other hand, active ETFs hire portfolio managers to actively invest their money, with the goal of outperforming a particular index.

Another important aspect to consider is expense ratios. ETFs charge fees, known as expense ratios, which are typically listed as an annual percentage. For example, a 1% expense ratio means you will be charged $10 in fees for every $1,000 invested. Lower expense ratios are generally preferable, as they reduce the overall cost of investing.

ETFs also distribute dividends, which can be paid out as cash or automatically reinvested through a dividend reinvestment plan (DRIP). It's worth noting that dividends and capital gains from ETFs held in a standard brokerage account may be subject to taxes. However, if you invest through an IRA, you can avoid immediate tax implications.

Unlike mutual funds, ETFs do not have strict minimum investment requirements. However, they trade on a per-share basis, so you'll need enough funds to purchase at least one share to get started, unless your broker offers fractional share purchases.

When choosing an ETF, it's important to consider the level of diversification it offers. ETFs generally provide exposure to a diverse range of stocks or bonds, reducing the risk associated with individual stock investments. However, it's important not to over-diversify, as this can lead to portfolio bloat and may dilute your expected returns.

Passive vs. active ETFs

There are two basic types of ETFs: passive and active. Passive ETFs, also known as index funds, are a popular strategy for investors who prefer a long-term, buy-and-hold approach. They are designed to track a specific index, such as the S&P 500, and have a very low-cost structure. The primary objective of passive ETFs is to replicate the performance of a specific benchmark index or asset class without active decision-making, and they are known for their transparency.

On the other hand, Active ETFs involve a fund manager who actively trades securities within the ETF to try to outperform a benchmark. Active ETFs are an option for investors who seek the potential for returns that exceed those of the broad market and other indexes. They have the potential to deliver above-average returns but tend to have higher management expenses. The fees for active ETFs cover the costs associated with research, trading, security selection, and ongoing portfolio management.

Passive ETFs

Passive ETFs are a convenient and low-cost way to implement indexing or passive investment management. Passive ETFs tend to follow buy-and-hold strategies and do not provide room for outperformance. They are designed to mirror the performance of a specific index, and the fund manager does not make allocation decisions beyond those that take place in the index itself. Passive ETFs also tend to have lower management fees compared to active ETFs.

Active ETFs

Active ETFs, on the other hand, involve a fund manager or management team that actively selects the ETF's portfolio securities and allocation according to the investment goals they wish to reach. These ETFs can provide investors with the potential for above-average returns. While active ETFs have the potential to outperform passive ETFs, they also have higher costs associated with active research, trading, and decision-making. Additionally, there is no guarantee that active ETFs will outperform passive ETFs.

When deciding between passive and active ETFs, it's important to consider your investment goals and style. If you prefer a long-term, buy-and-hold approach to building wealth, passive ETFs may be a better fit. On the other hand, if you're seeking higher returns and are willing to take on more risk, then active ETFs could be a better option. It's also worth noting that you don't have to choose just one type of ETF; you can include both passive and active ETFs in your portfolio to balance fees, risk, and potential returns.

Expense ratios

When considering investing in an ETF, it is essential to evaluate its expense ratio as part of the investment decision process. A high expense ratio can significantly affect your returns. The expense ratio of an ETF is typically expressed as a percentage of the fund's average net assets. For example, an expense ratio of 0.30% means you will pay $30 per year for every $10,000 invested in that fund.

It is important to note that expense ratios do not include brokerage commissions, transaction fees, or other fees paid to financial intermediaries for purchasing or selling ETF shares on secondary markets. These fees are separate and additional costs to consider when evaluating the total cost of owning an ETF.

When comparing different ETFs, it is crucial to look for funds with expense ratios below the asset-weighted average. As a general rule, the lower the expense ratio, the better, as it directly translates to lower costs for investors.

Actively managed ETFs tend to have higher expense ratios than passive, index-tracking funds. This is because active ETFs hire portfolio managers to invest their money, while passive ETFs simply track a stock index. Therefore, when deciding between active and passive ETFs, it is essential to consider the trade-off between the potential for higher returns with active management and the typically lower costs associated with passive funds.

Additionally, ETFs that invest in foreign securities generally have higher expense ratios than those investing in US Treasury bonds due to the increased costs of managing international investments.

Finally, it is worth noting that expense ratios for ETFs have been declining over the years, with many passive funds offering expense ratios below 0.10%, and some even offering expense ratios of 0%. This is excellent news for investors, as lower expense ratios mean more of your money is working for you, potentially generating higher returns over time.

In conclusion, when considering investing in an ETF, carefully evaluate the expense ratio to ensure you are not paying excessive fees that can eat into your investment returns. Compare different ETFs to find those with competitive expense ratios, and consider the trade-offs between active and passive fund management, as well as the types of securities the ETF invests in. Remember that lower expense ratios do not always mean worse performance, and in many cases, can result in higher returns over the long term.

Dividends and DRIPs

DRIPs allow investors to automatically reinvest their cash dividends to purchase additional shares or fund units of the ETF. This process is commission-free and provides a simple, efficient way to grow your investment portfolio over time. The ability to automatically reinvest dividends is now widely available, and most brokerages will allow you to set up a DRIP for any ETF that pays dividends.

One advantage of DRIPs is their convenience and ease of use. They eliminate the need to manually place orders, ensuring that your dividends are consistently working for you. Additionally, with DRIPs, you don't have to worry about timing the market, as your dividends are automatically reinvested.

However, one disadvantage of automatic dividend reinvestments is that investors lose the ability to time the market. Manual dividend reinvestment provides more control, allowing investors to wait if they anticipate a drop in the share price. It also offers the option to invest the dividends in a different security.

When setting up a DRIP, investors can choose between "all eligible securities" or "individual securities". It's important to note that leftover cash from a DRIP purchase will remain in the investor's account and will not accumulate towards new DRIPs. Additionally, DRIPs have currency restrictions, and investors must submit a new form if they plan to hold positions in multiple currencies.

It's worth mentioning that DRIPs are generally preferred over manual reinvestment due to the timing issues associated with ETF dividends. ETFs rely on brokerages to track shareholders, which can cause delays in dividend distribution and make manual timing more challenging.

Understanding ETF taxes

If you buy ETFs in a standard brokerage account (not an IRA), you should know that they could result in taxable income. Any gains you make from selling an ETF will be taxed according to capital gains tax rules, and any dividends you receive will likely be taxable as well.

Of course, if you invest in ETFs through an IRA, you won't have to worry about capital gains or dividend taxes. In a traditional IRA, money in the account is only considered taxable income after it is withdrawn, while Roth IRA investments aren't taxable at all in most cases.

ETFs have different tax rules depending on their assets. Profits from selling ETFs held for under a year are taxed as short-term capital gains, while those held for longer are considered long-term gains and are taxed at a lower rate.

If you sell an ETF and buy the same ETF after less than 30 days, you may be subject to the wash sale rule, which means you can't offset other capital gains. If an ETF purchase is underwater when you approach the one-year mark, you may consider selling it as a short-term capital loss.

High earners are also subject to the 3.8% net investment income tax on ETF sales.

ETFs are often said to have better tax treatment than mutual funds because of their structure. They create and redeem shares using in-kind transactions, which aren't considered sales and, therefore, don't trigger taxable events.

This arises from a section of the U.S. Internal Revenue Code of 1986, which exempts the distribution of capital gains when the shares whose values appreciated are given in kind to redeeming investors—the market makers for the ETFs.

Selling your shares in an ETF is a taxable event. Whether you have a long-term or short-term capital gain or loss depends on how long you've held the shares. In the U.S., you need to hold an ETF for more than a year to benefit from any sale being treated as long-term capital gains. If you hold it for a year or less, it's considered a short-term gain, typically resulting in a higher tax rate.

Mutual funds and ETFs are required to distribute capital gains and income to investors at least annually. It's important to pay attention to these estimates as there can be instances where the capital gains distributed represent a significant amount relative to the asset value. Investors may have the opportunity to sell a fund projecting a significant capital gain before the record date, thereby avoiding the taxable distribution. However, selling a position may create a taxable event, depending on the price and holding period of the investment.

Because of structural differences, mutual funds generally incur more capital gains year over year, while the ETF structure minimizes capital gains until shares are sold. Generally, ETFs are not only liquid and low-cost but also tax-efficient. Deferring annual capital gains allows more assets to remain invested and potentially compound at a higher rate. As a result, ETFs may be the optimal vehicle for investors keen on managing their annual tax bills.

Keep in mind that investors are also subject to capital gains tax if they earn a profit from trading their individual ETFs or mutual fund shares (i.e., selling for a higher price than they paid).

Frequently asked questions