Etf Makers: A Guide To Investing In Their Success

Exchange-traded funds (ETFs) are a type of investment fund that combines the best attributes of stocks and mutual funds. They offer the diversification benefits of mutual funds while mimicking the ease with which stocks are traded. ETFs are an excellent entry point for new investors into the stock market as they are cheap and typically carry lower risk than individual stocks.

ETFs are a basket of investments such as stocks or bonds, and they can be bought and sold on exchanges like stocks. They are also more tax-efficient than mutual funds. ETFs are usually passively managed, meaning they track an index, but there are also actively managed ETFs that aim to beat an index's performance.

ETFs can be set up by individuals, but it requires significant startup capital and financial expertise. Individuals can, however, invest in existing ETFs by working with a robo-advisor, consulting a financial advisor, or opening an account with a self-directed online brokerage.

Passive vs. active ETFs

There are two basic types of ETFs: passive and active. Passive ETFs, also known as index funds, are designed to track a stock index, such as the S&P 500. Active ETFs, on the other hand, hire portfolio managers to actively select stocks and make investment decisions with the goal of beating the market and generating higher returns.

Passive ETFs are often considered a more convenient and cost-effective option for investors, as they have lower management fees and don't require active decision-making. They are ideal for those who prefer a long-term, buy-and-hold investment strategy. On the other hand, active ETFs offer more flexibility and the potential for higher returns but come with higher costs and rely on the expertise of portfolio managers.

Passive ETFs tend to follow a buy-and-hold strategy, aiming to replicate the performance of a specific benchmark index. They are known for their transparency and low costs, as they generally have lower management fees. However, they do not provide any opportunity for outperformance.

Active ETFs, in contrast, utilise a portfolio manager's investment strategy and actively trade securities within the ETF to try to outperform a benchmark. These ETFs aim to deliver above-average returns but come with higher management expenses due to the active research, trading, and decision-making involved.

When deciding between passive and active ETFs, it's important to consider your investment goals, time horizon, and risk tolerance. Passive ETFs are generally suitable for those seeking a long-term, low-cost investment strategy, while active ETFs may be preferred by those seeking higher returns and more flexibility.

Expense ratios

The expense ratio is one of the most important factors to consider when investing in an ETF or mutual fund. A high expense ratio can significantly impact your returns, and it pays for things like fund management, marketing, advertising, and other running costs.

The expense ratio for an ETF is typically low compared to mutual funds. While ETF expense ratios average about 0.22%, mutual fund costs can be significantly higher. As of 2023, equity mutual fund expense ratios averaged 0.42%, hybrid funds averaged 0.58%, and bond funds averaged 0.37%.

Over the past few decades, fund expense ratios have been trending lower. This is due to a rise in investor interest in low-cost equity funds, and a shift towards no-load funds.

When choosing an investment fund, it is important to note that even small differences in expense ratios can have a significant impact on your investment over time. A fund with a high expense ratio could cost you ten times what you might otherwise pay with a lower ratio fund.

Actively managed funds tend to have higher expense ratios than passively managed funds, as they require a team of portfolio managers to operate the fund.

When comparing funds, it is best to compare funds that own similar types of investments. For example, international funds, which operate in multiple countries, tend to be more expensive to run than large-cap funds.

When researching investments, there are several ways to determine the expense ratio of a fund:

• Fund Prospectus: The prospectus will be mailed or sent electronically to shareholders each year, and the expense ratio can typically be found under the "Shareholder Fees" heading.
• Financial News Websites: Websites such as Google Finance and Yahoo! Finance provide expense ratio information for mutual funds and ETFs.
• Fund Screeners: Online ETF and mutual fund screeners allow you to search by category or group and compare expense ratios across similar investments.
• News Journals: Print newspapers, such as Investor's Business Daily and The Wall Street Journal, also print information on funds, including expense ratios.

When it comes to choosing an ETF, it is generally recommended to opt for passively managed index funds, as they tend to be cheaper than actively managed funds. Funds based on major indices, such as the S&P 500, typically have the lowest expense ratios.

It is worth noting that some funds, particularly index funds, may have expense ratios below 0.10% or even 0%.

By choosing funds with lower expense ratios, you can minimize fees and maximize your investment returns over time.

Dividends and DRIPs

Most ETFs pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. You can choose to have your ETF dividends paid to you as cash, or you can choose to have them automatically reinvested through a dividend reinvestment plan, or DRIP.

A dividend reinvestment plan (DRIP) is a program that allows investors to reinvest their cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date. DRIPs are offered by the fund or brokerage firm and are now widely available. They offer a convenient way to grow your investments with minimal effort.

DRIPs offer several advantages for both the investor and the company. For investors, DRIPs provide a way to accumulate more shares without paying a commission. Many companies offer shares at a discount through their DRIP. DRIPs also allow investors to buy fractional shares, so every dividend dollar is utilised. Over time, DRIPs can compound returns as increases in dividends result in a larger number of shares being purchased.

For companies, DRIPs create more capital and shareholders who participate in DRIPs are less likely to sell their shares when the market declines.

While DRIPs are a convenient way to reinvest dividends, there are some disadvantages. Reinvesting dividends means you don't receive the cash, which could be used for other purposes or invested elsewhere. Additionally, dividends paid into DRIPs are taxed, and if you don't receive the cash payout, you'll need to pay taxes from your own funds.

Another option for reinvesting ETF dividends is to do it manually. This provides more control and allows you to time the market, but it is less convenient and may incur commission charges.

ETF taxes

Exchange-traded funds (ETFs) are generally considered more tax-efficient than mutual funds. This is because ETFs are structured to minimise taxes for the holder, resulting in a lower tax bill than a similar mutual fund. However, it's important to note that taxes on ETFs depend on various factors, including the type of ETF, the holding period, and the investor's income.

• Taxable Events: ETFs have fewer "taxable events" than mutual funds. Mutual funds often trigger capital gains taxes when they sell securities to accommodate redemptions or reallocate assets. In contrast, ETF managers create or redeem "creation units", baskets of assets representing the ETF's investment exposure, reducing the likelihood of capital gains on individual securities.
• Capital Gains Taxes: When you sell an ETF, any gains are generally taxed based on the holding period and your income. Long-term capital gains taxes apply if you hold the ETF for more than a year, with rates up to 23.8% (including the Net Investment Income Tax, or NIIT). Short-term capital gains are taxed at ordinary income rates, up to 40.8%.
• Dividends and Interest: ETFs that hold dividend-paying stocks will distribute those earnings to shareholders, typically once a year. Dividends are taxed at different rates depending on whether they are "qualified" or "ordinary". Qualified dividends may be taxed at lower capital gains rates, while ordinary dividends are taxed at ordinary income rates. Interest distributed by bond ETFs is also taxed as ordinary income.
• Commodity ETFs: ETFs that invest in commodities like oil, corn, or metals may use futures contracts. These ETFs can be structured as limited partnerships, requiring tax reporting on Schedule K-1, and are subject to the 60/40 rule for gains and losses, which are treated as 60% long-term and 40% short-term, regardless of the holding period.
• Precious Metals ETFs: ETFs focused on precious metals like gold and silver are often structured as grantor trusts. The IRS treats these as investments in collectibles, resulting in a maximum long-term capital gains rate of 31.8% and short-term gains taxed as ordinary income.
• Currency ETFs: These ETFs can be structured as open-end funds, grantor trusts, or limited partnerships, each with different tax implications. Open-end funds and grantor trusts are taxed at long-term and short-term capital gains rates, while limited partnerships follow the 60/40 rule.
• Wash Sales: Selling an ETF and buying the same or a "substantially identical" ETF within 30 days may trigger the wash sale rule, disallowing the offset of capital gains with capital losses. This practice has been used by some investors to artificially book losses without changing their investment positions.
• Tax Strategies: ETFs can be used for tax planning. For example, selling ETFs with losses before their one-year anniversary and holding ETFs with gains past the one-year mark can take advantage of long-term capital gains treatment. Additionally, selling an ETF in a declining sector and buying another with a similar but different index can help capture losses for tax purposes while maintaining exposure to that sector.

Pros and cons of ETFs

Exchange-traded funds (ETFs) are a popular investment vehicle, with the global value of ETFs surpassing $10 trillion by 2021. They are an easy way to begin investing, offering simplicity and broad market exposure. ETFs are also a powerful type of investment, offering certain advantages over other types of investments such as individual stocks or mutual funds.

Pros of ETFs

• Exposure to a variety of stocks, bonds, and other assets: ETFs allow investors to buy many stocks or bonds at once, providing exposure to a variety of stocks, bonds, and other assets, typically at a minimal expense.
• Take the guesswork out of stock investing: ETFs allow investors to match the market's performance over time, which has historically been quite strong.
• More liquid than mutual funds: ETFs are easier to buy and sell than mutual funds. Online brokers make it easy to trade ETFs with a simple click of the mouse.
• Low expense ratios: ETFs have lower expense ratios than actively managed mutual funds, which means less cost to investors and enhanced potential returns.
• Tax-efficient: ETFs are more tax-efficient than mutual funds because they have fewer trades, resulting in smaller capital gains and losses.
• Risk management: ETFs offer risk management through diversification.
• Access to targeted industries: ETFs exist that focus on specific industries, allowing investors to gain exposure to particular sectors.
• Flexibility: In addition to trading during regular hours, ETF investors can wager on declining markets by short-selling ETFs.

Cons of ETFs

• Costs: ETFs are often low-cost, but they aren't free. Buying and selling ETFs incurs trading fees, and ETFs also have expense ratios, which cover management costs.
• Limited diversification in some cases: Some ETFs may be limited to large-cap stocks due to a narrow group of equities in the market index, limiting exposure to mid- and small-cap companies.
• Lower returns: Since ETFs own a diverse assortment of stocks, they don't have quite as much return potential as buying individual stocks.
• Lower dividends: ETFs might pay dividends, but the yields may be lower than those obtained by owning high-yielding stocks.
• Not ideal for hands-on investors: Investors who want to be hands-on and select specific companies or asset classes to invest in based on their values may find ETFs challenging, as they may end up investing in companies they don't want to support.

Frequently asked questions