Etfs: An Introduction To Exchange-Traded Funds Investing

Exchange-Traded Funds (ETFs) are SEC-registered investment companies that allow investors to pool their money in a fund that invests in stocks, bonds, or other assets. ETFs are bought and sold like common stock on a stock exchange, and they can be traded during market hours. They are considered more tax-efficient than actively managed mutual funds and are a good option for investors looking for an affordable, diversified investment.

ETF vs Mutual Funds

Exchange-traded funds (ETFs) and mutual funds are both "baskets" of securities, like stocks or bonds, that are managed by experts. However, there are some key differences between the two investment options.

ETFs trade like stocks and are bought and sold on a stock exchange, with price changes throughout the day. This means that the price at which you buy an ETF will likely differ from the prices paid by other investors. Mutual funds, on the other hand, are executed once per day, with all investors receiving the same price. Mutual funds can only be purchased at the end of each trading day, based on a calculated price known as the net asset value (NAV).

ETFs do not require a minimum initial investment and are purchased as whole shares. You can buy an ETF for the price of just one share, usually referred to as the ETF's "market price." Mutual funds, however, typically have a minimum investment requirement of hundreds or thousands of dollars. Mutual fund minimum initial investments are normally a flat dollar amount and are not based on the fund's share price.

While they can be actively or passively managed, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds usually come in both active and indexed varieties, but most are actively managed by fund managers. Actively managed funds tend to have higher fees and higher expense ratios due to their higher operations and trading costs.

ETFs can potentially generate fewer capital gains for investors since they may have lower turnover and can use the in-kind creation/redemption process to manage the cost basis of their holdings. A sale of securities within a mutual fund may trigger capital gains for shareholders, even if they have an unrealized loss on the overall mutual fund investment. ETFs are generally considered to be more tax-efficient than actively managed mutual funds.

This depends on your goals and the type of investor you are. Consider an ETF if you want lower investment minimums, more hands-on control over the price of your trade, or an index fund. A mutual fund may be more suitable if you want to repeat specific transactions automatically or if you invest frequently.

ETF Trading

Exchange-traded funds (ETFs) are a type of investment vehicle that combines the flexibility of stocks with the diversification benefits of mutual funds. ETFs are bought and sold like stocks on a stock exchange, offering intraday trading and real-time pricing. They provide access to a diverse mix of asset classes, including stocks, bonds, commodities, and currencies.

ETFs are typically structured as baskets of securities, such as stocks or bonds, that track a specific index like the S&P 500 or NASDAQ. They can also be designed to focus on a particular industry, such as oil, pharmaceuticals, or technology. Additionally, ETFs may be actively managed or passively managed. Actively managed ETFs aim to outperform an index, while passively managed ETFs seek to replicate the performance of an index.

One of the key advantages of ETFs is their affordability. They generally have lower operating expense ratios (OERs) compared to actively managed mutual funds, making them accessible to a wide range of investors. ETFs are also known for their tax efficiency, as they may generate fewer capital gains for investors due to lower turnover and the use of the in-kind creation/redemption process.

When investing in ETFs, it is important to consider the associated costs, such as trading commissions, operating expense ratios, and bid/ask spreads. Additionally, ETFs may have lower liquidity, resulting in wider bid/ask spreads, and tracking errors, causing discrepancies between the ETF and its underlying index.

Overall, ETFs provide investors with a flexible, diverse, and affordable investment option, making them a popular choice for those seeking to achieve their investment goals.

ETF Costs

As with any investment, it is important to understand the costs involved when investing in an ETF. While ETFs are generally considered a low-cost investment option, there are still various fees and expenses that investors should be aware of. Here is an overview of the typical costs associated with ETFs:

• Brokerage Commissions: Some brokerages charge a commission for buying or selling an ETF, similar to the fees for trading stocks. However, it is worth noting that there are also commission-free ETFs available in the market.
• Operating Expense Ratio (OER): The OER is the ongoing management fee charged by the fund's sponsor, expressed as a percentage of the fund's assets. This fee covers the fund's operating expenses, such as portfolio management, administration, and distribution costs. The OER can vary widely depending on the ETF, with passively managed ETFs typically having lower fees than actively managed funds.
• Bid/Ask Spreads: This refers to the difference between the bid price (the highest price a buyer is willing to pay) and the ask price (the lowest price a seller is willing to accept) for an ETF share. The spread can vary from one ETF to another and tends to be larger for ETFs with low trading volume.
• Premiums and Discounts: ETFs may trade at a premium or discount to their net asset value (NAV). This means that the market price of the ETF may be higher or lower than the underlying value of the assets it holds.
• Trading Costs: If you plan to trade ETFs frequently, especially with small investment amounts, there may be lower-cost alternatives, such as investing directly with a fund company in a no-load fund.
• Illiquidity: Some thinly traded ETFs may have wide bid/ask spreads, resulting in higher costs when buying or selling.
• Tracking Error: While ETFs generally track their underlying index or asset, technical issues or other factors can create discrepancies, leading to potential losses for investors.

It is important to carefully review the prospectus and fee structure of an ETF before investing to fully understand the costs involved. Additionally, investors should consider the impact of these costs on their investment strategy and return expectations.

ETF Tax Efficiency

Exchange-traded funds (ETFs) are generally considered to be more tax-efficient than mutual funds. This is because ETFs have a unique mechanism for buying and selling, which means they usually don't generate the capital gains distributions that mutual funds do and, therefore, don't see the tax effects of those distributions.

ETFs use "creation units" that allow for the purchase and sale of assets in the fund collectively. This means that ETFs don't create taxable events in the same way that actively managed mutual funds do. Actively managed funds experience taxable events when selling the assets within them.

ETFs are also passively managed, which creates fewer transactions because the portfolio only changes when there are changes to the underlying index it replicates.

However, ETFs that hold dividend-paying stocks will ultimately distribute earnings to shareholders, usually once a year. Dividend-focused ETFs may do so more frequently. Qualified dividends may be taxed at lower capital gains rates if certain conditions are met; otherwise, you'll be taxed at the ordinary income rate, which tops out at 40.8%.

If you sell an ETF, any gains will be taxed based on how long you owned it and your income. For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate of up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners. If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.

Certain international ETFs, particularly emerging market ETFs, have the potential to be less tax-efficient than domestic and developed market ETFs. This is because many emerging markets are restricted from performing in-kind deliveries of securities. Therefore, an emerging-market ETF might have to sell securities to raise cash for redemptions, triggering a taxable event.

Leveraged and inverse ETFs have also proven to be relatively tax-inefficient vehicles. Many of these funds have had significant capital gain distributions on both the long and short funds.

Commodity ETFs are also less tax-efficient than other ETFs because they invest in commodities via futures contracts. Many of these ETFs are structured as limited partnerships and will report your income on Schedule K-1 instead of Form 1099. Another noteworthy tax feature of commodity ETFs is the 60/40 rule, which states that any gains or losses realized by selling these types of investments are treated as 60% long-term gains and 40% short-term gains, regardless of how long you've held the ETF.

Precious metals ETFs involve a different set of tax issues. ETFs backed by physical metals are structured as grantor trusts, which the IRS treats as an investment in collectibles. The maximum long-term capital gains rate on collectibles is 31.8%, including the NIIT, and short-term gains are taxed as ordinary income.

Types of ETFs

Exchange-traded funds (ETFs) are a type of investment fund that pools capital from investors and purchases securities. They can be bought and sold on a stock exchange like stocks, making them extremely liquid. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of securities.

Passive ETFs

Passive ETFs aim to replicate the performance of a broader index, such as the S&P 500 or a more specific targeted sector or trend. They are designed to track an index rather than outperform it.

Actively Managed ETFs

Actively managed ETFs do not target an index of securities but instead have portfolio managers making decisions about which securities to include in the portfolio. These ETFs are designed to outperform an index and have benefits over passive ETFs, but they can be more expensive for investors.

Bond ETFs

Bond ETFs are used to provide regular income to investors. The distribution depends on the performance of underlying bonds, which may include government, corporate, and municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date.

Stock ETFs

Stock ETFs are a basket of stocks that track a single industry or sector, like automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, including high performers and new entrants with growth potential. Stock ETFs have lower fees than stock mutual funds and do not involve actual ownership of securities.

Sector or Industry ETFs

Sector or industry ETFs focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector.

Commodity ETFs

Commodity ETFs invest in commodities like crude oil or gold. They can diversify a portfolio and make it easier to hedge against market downturns. Holding shares in a commodity ETF is cheaper than physical possession of the commodity.

Currency ETFs

Currency ETFs track the performance of currency pairs consisting of domestic and foreign currencies. They can be used to speculate on currency prices based on political and economic developments and to diversify a portfolio or hedge against volatility in forex markets.

Inverse ETFs

Inverse ETFs earn gains from stock declines by shorting stocks. An inverse ETF uses derivatives to short a stock and is considered an exchange-traded note (ETN).

Leveraged ETFs

A leveraged ETF seeks to return multiples on the return of the underlying investments. These products use debt and derivatives to leverage their returns.

Frequently asked questions