Etfs: Smart Investing Or Overhyped?

Exchange-traded funds (ETFs) are a popular investment vehicle for both active and passive investors. They are similar to mutual funds but trade like stocks, allowing investors to broaden the diversity of their portfolios without increasing the time and effort spent on managing and allocating their investments. ETFs are ideal for young investors as they require small amounts of capital to begin with and provide ample liquidity. They are also highly accessible, with no minimum investment amounts, and can be traded throughout the day on the open market. However, investors need to be aware of the disadvantages of ETFs, such as commissions and expenses, underlying fluctuations and risks, and capital gains distributions.

Low Fees

Exchange-traded funds (ETFs) are a great investment option for those seeking a simple, low-cost way to invest in the market. ETFs are similar to mutual funds in that they pool money from multiple investors to buy stocks, bonds, or other assets. However, they differ in that ETF shares are sold in blocks to brokerages, which then sell them on the open market to individual investors. This means that ETFs can be traded throughout the day, just like stocks.

One of the main advantages of ETFs is their low fees. Here are some of the reasons why ETFs have lower fees compared to other investment options:

• Passive management: Most ETFs are passively managed, meaning they track a specific stock index rather than having a dedicated fund manager making investment decisions. This passive management style results in less research and fewer trades, keeping ongoing costs low.
• Low expense ratios: ETFs are known for having very low expense ratios, which is the percentage of a fund's total assets used to cover operating expenses. While a higher expense ratio doesn't directly equate to a fee paid by the investor, it does reduce their total returns.
• No minimum investment: Unlike mutual funds, which often require an initial investment of several hundred or even thousands of dollars, ETFs have no minimum investment amounts. The price of an ETF share depends on its current market price, which fluctuates throughout the trading day. This makes ETFs more accessible to investors with limited capital.
• Fractional shares: Some brokerages, such as Robinhood, offer the ability to invest in fractional shares of ETFs, allowing investors to buy a portion of a share for as little as $1. This further reduces the cost barrier to investing in ETFs.

It's important to note that while ETFs have lower fees overall, they do still incur some costs. For example, every time you buy or sell an ETF, you may pay a trading fee or commission, similar to trading stocks. Additionally, ETFs have ongoing management fees, known as expense ratios, which will reduce your potential returns. Therefore, it's essential to consider the fee structure of any ETF you're considering investing in.

Tax Efficiency

Exchange-traded funds (ETFs) are considered a tax-efficient investment vehicle due to their ability to minimise taxes during the holding period. ETFs generally generate low capital gains tax liabilities from distributions for the following reasons:

Low Portfolio Turnover

ETFs tend to have low turnover, which reduces the number of realised gains that need to be distributed. However, it's important to note that different ETFs have different levels of internal turnover, so investors should review a fund's prospectus before investing.

Long-term Capital Gains

The low turnover in ETFs often results in a longer holding period for each of the underlying investments. ETFs typically hold underlying securities for more than 12 months, which qualifies any gains that are realised for favourable long-term capital gains tax rates.

Secondary Market Transactions

When ETF investors sell their shares on the stock exchange to other investors, the ETF portfolio manager does not need to buy or sell any of the ETF's underlying investments. This means that one investor's decision to sell does not impact other investors, helping to keep capital gains distributions low.

Primary Market Transactions

ETFs have a unique creation and redemption mechanism that allows authorised participants (APs) to build or disassemble baskets of ETF shares in response to changes in demand. These primary market transactions are typically conducted in-kind, meaning securities are exchanged for ETF shares rather than cash. These in-kind transactions do not trigger a taxable event for the fund, improving the tax efficiency of ETFs.

Comparison to Mutual Funds

While both ETFs and mutual funds are subject to similar tax considerations, such as taxation on dividends and capital gains distributions, ETFs are generally considered more tax-efficient due to their structure and how they are traded. ETFs typically generate fewer capital gains than mutual funds, resulting in lower tax implications for investors.

Tax Implications of ETFs

It is important to note that ETFs do have tax consequences, and investors should be aware of the potential tax bill associated with their investments. Distributions from ETFs can be taxed as qualified or non-qualified dividends, interest, or capital gains, depending on the source. Additionally, certain types of ETFs, such as those backed by physical metals or structured as grantor trusts, may have specific tax treatments.

Accessibility

ETFs are highly accessible to investors. They can be traded throughout the day on the open market, offering the diversification benefits of a mutual fund with the ease of trading stocks. ETFs can be purchased through individual retirement accounts or individual brokerage accounts.

There is no minimum investment amount for ETFs, and fractional shares can be bought for as little as $1 through online brokerage firms such as Robinhood and Stash. The price of an ETF share depends on its current market price, which fluctuates throughout the trading day.

ETFs are also accessible to investors with limited capital and knowledge of investing. They allow investors to build a diversified portfolio with less capital. For example, a young investor with $2,500 to invest can use ETFs to gain exposure to U.S. equities, gold, and the Japanese yen.

ETFs are also a good option for beginner investors as they typically don't require a lot of money to start investing, and their ongoing administrative costs are generally low.

Outperformance

Passively managed ETFs that track a specific index don't usually offer the potential to outperform the market in the same way that actively managed funds do. This means that if your goal is to beat the market, an ETF might not be the best option.

However, it's important to note that not all ETFs are passively managed. Some ETFs, known as smart-beta ETFs, combine the benefits of passive and active investing strategies to achieve higher returns. These funds use rule-based investment filters to select stocks based on specific criteria, such as low volatility, value, quality, or momentum. By tweaking the allocation of the index, smart-beta ETFs aim to achieve a better risk-reward ratio and enhance returns.

Smart-beta ETFs have become increasingly popular, particularly among millennials, due to their potential to generate better risk-adjusted returns at a lower cost. However, it's worth noting that the performance of smart-beta ETFs can be cyclical, and individual factors can underperform simple diversified funds or index funds for extended periods.

Additionally, it's important to remember that past performance is not always indicative of future results. While analysing the historical returns of different factors can provide valuable insights, investing based solely on this information may not be a prudent strategy.

Costs

While ETFs are considered a low-cost investment option, there are some costs associated with them that investors should be aware of. Here are the main costs to consider when investing in ETFs:

• Commissions and Trading Fees: Every time you buy or sell an ETF, you may have to pay a commission or trading fee. These fees can add up, especially if you trade frequently, and impact your overall investment performance. Some brokers offer zero-commission trading for ETFs, but there may still be hidden costs, such as payment for order flow (PFOF), which can impact the price you get.
• Expense Ratio: ETFs have an expense ratio, which is a percentage of the fund's total assets used to cover operating expenses. While ETFs typically have very low expense ratios compared to other investment vehicles, it is still a cost that will impact your returns. The expense ratio is an important factor to consider when comparing similar ETFs.
• Management Fees: ETFs may charge management fees, which are typically included in the expense ratio. These fees cover the cost of fund managers and advisers.
• Bid-Ask Spreads: The difference between the bid and ask prices of an ETF, known as the bid-ask spread, represents the cost of buying and selling the ETF. Large spreads between the bid and ask prices can indicate an illiquid investment, which may result in higher costs when entering or exiting a position.
• Capital Gains Taxes: If an ETF distributes capital gains to shareholders, investors are responsible for paying capital gains taxes on those distributions. This can reduce the overall returns of the investment.
• Reinvestment Costs: When an ETF distributes capital gains, investors who want to reinvest those gains may need to pay additional fees to their brokers to purchase more shares.

It is important to carefully consider the cost structure of ETFs before investing and compare them with other investment options, such as mutual funds, to make an informed decision. Additionally, investors should be mindful of the potential impact of these costs on their overall investment returns over time.

Frequently asked questions