Etfs: Choosing The Right Investment For You

Exchange-traded funds (ETFs) are a great way to enter the stock market for beginners. They are a collection of stocks, bonds, commodities, or a combination of these, and each share you purchase gives you a slice of all of them. This is an easy way to diversify your portfolio. ETFs are also relatively inexpensive and tend to be less risky than investing in individual stocks.

ETFs are traded like stocks on major exchanges such as the NYSE and Nasdaq. They can be designed to track specific investment strategies, and various types of ETFs are available for income generation, speculation, and price increases. The SPDR S&P 500 ETF (SPY) was the first ETF launched in 1993, tracking the S&P 500 Index.

ETFs have lower fees than mutual funds and are more tax-efficient. They also offer instant diversification by investing in many assets at once, which can be a good way to invest in some of the largest companies in the country with the goal of long-term returns.

When choosing an ETF, consider factors such as its level of assets, trading volume, and the underlying index. It is also important to evaluate your financial plan and consider your investment goals and risk tolerance.

ETFs vs. mutual funds

Exchange-traded funds (ETFs) and mutual funds are similar in many ways. Both are professionally managed collections or "baskets" of individual stocks or bonds. They are both less risky than investing in individual stocks and bonds and offer built-in diversification. They also provide access to a wide variety of investment options, overseen by professional portfolio managers.

However, there are some key differences between the two. Here are some of the most important ones:

• ETFs trade like stocks and are bought and sold on a stock exchange, experiencing price changes throughout the day. Mutual funds, on the other hand, are priced once per day, and you typically invest a set dollar amount.
• ETFs do not require a minimum initial investment and are purchased as whole shares, whereas mutual funds usually have a flat dollar amount as a minimum initial investment.
• ETFs are usually passively managed, tracking a market index or sector sub-index, while mutual funds can be actively or passively managed.
• ETFs are generally more tax-efficient than mutual funds as they may have lower turnover and can use the in-kind creation/redemption process to manage the cost basis of their holdings.
• ETFs provide more hands-on control over the price of your trade with real-time pricing and more sophisticated order types.
• ETFs are often cheaper to invest in, with no minimum investment requirements beyond the price of one share. Mutual funds typically have minimum investment requirements of hundreds or thousands of dollars.
• ETFs are usually passively managed, while mutual funds can be actively or passively managed, although most are actively managed.

Passive vs. active ETFs

When it comes to investing in ETFs, you have the option to choose between passive and active funds. Both have their pros and cons, and your decision will depend on your investment goals and style.

Passive ETFs

Passive ETFs are designed to track a stock index, such as the S&P 500. They aim to replicate the performance of a specific index, allowing investors to benefit from the overall market performance. These funds are passively managed, meaning they are not actively traded and have limited transactions. Passive ETFs tend to be lower-cost and more transparent than active ETFs. They are also considered less risky and are often used as part of a long-term investment strategy. Additionally, they usually have lower management fees and expense ratios compared to active ETFs.

Active ETFs

On the other hand, active ETFs hire portfolio managers and analysts to actively select and manage the fund's investments. The goal of active ETFs is to outperform the benchmark index and generate higher returns. Active fund managers buy and sell stocks based on their research and experience, incorporating only those stocks they believe have the potential to beat the market. Active ETFs offer more flexibility and adaptability in terms of stock selection. However, they generally have higher fees and expense ratios due to the costs associated with active management and trading.

The choice between passive and active ETFs depends on your investment goals and style. If you prefer a long-term, buy-and-hold strategy and want to minimise costs, passive ETFs may be more suitable. On the other hand, if you seek higher returns and are willing to take on more risk, active ETFs could be a better option. Ultimately, you can also choose to include both types of ETFs in your portfolio to balance fees, risk, and potential returns.

Expense ratios

ETFs are known for having low expense ratios, and this is one of the reasons why they are a good option for beginner investors. The average equity ETF expense ratio is 0.15%, compared to 0.42% for an equity fund.

When choosing an ETF, it is worth considering the expense ratio, as even small differences can add up over time. However, it is also important to evaluate the ETF based on other factors such as its level of assets, trading volume, and underlying index.

Dividends and DRIPs

Most ETFs pay dividends. Dividends are the profits paid to investors from shares of stocks or mutual funds. Dividends can be paid out as cash or automatically reinvested through a dividend reinvestment plan or DRIP. Dividend reinvestment plans are a program offered by a fund or brokerage firm that allows investors to have their dividends automatically used to purchase additional shares of the issuing security.

DRIPs are a smart idea because there is often a longer settlement time required by ETFs. Their market-based trading can make manual dividend reinvestment inefficient. DRIPs are also a good idea because they eliminate the problems with timing the reinvestment of ETF dividends.

There are two types of dividend reinvestment: automatic and manual. Automatic dividend reinvestment is when a DRIP is set up and dividends are automatically reinvested, eliminating the need to place orders manually. This is a "set it and forget it" approach that ensures dividends are consistently working for the investor. The other type of dividend reinvestment is manual dividend reinvestment, which is less convenient but provides more control. With manual dividend reinvestment, the investor can elect to wait if they feel the share price may drop rather than simply paying the market price for new shares on the payment date.

There are some disadvantages to automatic dividend reinvestment. For example, investors lose the ability to time the market. Additionally, automatic dividend reinvestment may not be available for all ETFs. However, most brokerages will allow investors to set up a DRIP for any ETF that pays dividends.

Major online brokerages such as Vanguard and Questrade offer commission-free dividend reinvestments.

ETF taxes

The tax efficiency of exchange-traded funds (ETFs) is one of their key advantages, especially when compared to mutual funds. However, the tax implications of ETFs can be complex and depend on various factors, including the type of ETF, the holding period, and the investor's jurisdiction. Here's what you need to know about ETF taxes:

Taxable Events

One of the main reasons for ETFs' tax efficiency is that they typically have fewer "taxable events" than mutual funds. In a mutual fund, when the fund manager sells securities to accommodate redemptions or reallocate assets, it creates capital gains for shareholders, even if they have an unrealized loss on their overall investment. In contrast, ETF managers create or redeem "creation units", baskets of assets representing the ETF's investment exposure, which minimizes the chances of capital gains on individual securities for the investor.

Capital Gains Taxes

When you sell an ETF and realize a capital gain, the tax treatment depends on the holding period and your income. In the US, if you hold the ETF for more than a year, the gain is typically taxed as a long-term capital gain, with rates up to 23.8% (including the Net Investment Income Tax, or NIIT). If you hold the ETF for a year or less, it's considered a short-term gain and is taxed at ordinary income rates, up to 40.8%.

Dividends and Interest

ETFs that hold dividend-paying stocks will distribute those dividends to shareholders, and these are taxed according to their qualification. 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.

Special Cases: Commodity, Currency, and Precious Metal ETFs

ETFs that invest in commodities, currencies, and precious metals have special tax rules. Commodity ETFs that use futures contracts may be structured as limited partnerships, requiring Schedule K-1 for tax reporting, and their gains are taxed using the 60/40 rule (60% as long-term gains and 40% as short-term gains, regardless of the holding period). Precious metal ETFs that hold physical metals are treated as "collectibles", with long-term gains taxed at a higher rate of up to 28%. Currency ETFs may be structured as grantor trusts, with gains taxed as ordinary income, or as limited partnerships, using the 60/40 rule.

Tax Strategies

ETFs can be used for tax planning strategies, such as tax-loss harvesting, where losses are realized before the one-year mark, and gains are held past the one-year mark to take advantage of long-term capital gains rates. Additionally, investors can switch between similar but different ETFs to maintain exposure to a sector while still realizing tax losses.

Frequently asked questions