Etfs: When To Invest For Maximum Returns

Exchange-traded funds (ETFs) are a great way to begin investing in the stock market. They are relatively simple to understand and can generate impressive returns without much expense or effort.

ETFs are a pooled investment security that can be bought and sold like an individual stock. They can be structured to track anything from the price of a commodity to a large and diverse collection of securities. ETFs can even be designed to track specific investment strategies.

ETFs are often low-cost, tax-efficient instruments for investors to track popular indexes or leverage experienced manager choices to beat the market. They are traded throughout the day on an exchange, like individual stocks, and offer investors an efficient way to gain exposure to the markets.

Some of the best-performing ETFs in November 2024 included the ARK Innovation ETF and the ARK Space Exploration & Innovation ETF.

When deciding when to invest in an ETF, it is important to consider factors such as risk, the fund's expense ratio, and the investor's financial goals and risk tolerance.

ETFs vs. mutual funds

Exchange-traded funds (ETFs) and mutual funds are both professionally managed collections or "baskets" of individual stocks or bonds. They are less risky than investing in individual stocks and bonds and offer a wide variety of investment options. However, there are some key differences between the two.

While both can be actively or passively managed, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds, on the other hand, come in both active and indexed varieties, but most are actively managed by fund managers.

ETFs trade like stocks and are bought and sold on a stock exchange, with price changes throughout the day. Mutual fund orders, however, are executed once per day, with all investors receiving the same price.

Minimum Investment

ETFs do not require a minimum initial investment and are purchased as whole shares. Mutual funds, on the other hand, usually have a flat dollar amount as their minimum initial investment and can be purchased in fractional shares or fixed dollar amounts.

Costs and Tax Efficiency

ETFs have implicit and explicit costs, including trading commissions and operating expense ratios. Mutual funds may be purchased without trading commissions but may carry other fees, such as sales loads or early redemption fees. ETFs can also be more tax-efficient, potentially generating fewer capital gains for investors due to lower turnover and the use of the in-kind creation/redemption process.

Control Over Trade Price

ETFs provide real-time pricing and allow for more sophisticated order types, giving investors more control over the price. Mutual funds offer a simpler approach, with the same price for all investors regardless of the time of day the order is placed.

Automatic Investments and Withdrawals

Mutual funds allow for automatic investments and withdrawals, while ETFs do not have this feature.

Suitability

Whether you choose an ETF or a mutual fund depends on your goals and investment style. ETFs are suitable if you want lower investment minimums, more control over the price of your trade, or an index fund. Mutual funds are a good choice if you invest frequently, want to set up automatic transactions, or are looking for a fund that could potentially outperform the benchmark index.

Passive vs. active ETFs

There are two main types of Exchange-Traded Funds (ETFs): passive and active. Both have their advantages and disadvantages, and investors may choose one or the other depending on their investment goals and preferences.

Passive ETFs

Passive ETFs are designed to replicate the performance of a specific index, such as the S&P 500 or Nasdaq. This means that the ETF will hold the same securities as the index it tracks and aim to deliver the same returns. Passive ETFs tend to have lower fees than active ETFs because they do not require active management. The fund manager of a passive ETF simply needs to ensure that the ETF matches the performance of the index it is tracking.

Passive ETFs are suitable for investors who prefer a long-term, buy-and-hold investment strategy. They offer broad diversification and low costs, making them a popular choice for investors who want to track the performance of a particular index or market.

Active ETFs

On the other hand, active ETFs aim to outperform a specific benchmark or index. These ETFs have a portfolio manager who actively selects the securities that go into the ETF and makes allocation decisions based on their research and investment strategy. Active ETFs may have higher fees than passive ETFs due to the cost of research and active management.

Active ETFs are suitable for investors who are seeking returns that are higher than the market average and are willing to take on more risk to achieve those returns. These ETFs offer more flexibility and the potential for higher returns but also come with the risk of underperforming the market.

Both passive and active ETFs have their advantages and can be used in an investment portfolio. Passive ETFs offer broad diversification and low costs, while active ETFs offer the potential for higher returns. Investors can choose one or a combination of both types of ETFs, depending on their investment goals, risk tolerance, and preferences.

Expense ratios

When deciding when to invest in an ETF, it is important to consider the expense ratio. The expense ratio is the cost to operate and manage the fund. It is expressed as an annual percentage and indicates how much of your investment in a fund will be deducted as fees. For example, a 1% expense ratio means that you will pay $10 in fees for every $1,000 you invest.

ETFs are known for having low expense ratios, which is one of the reasons they are a popular investment choice. According to Morningstar, the asset-weighted average expense ratio for ETFs and mutual funds was 0.36% in 2023. When choosing an ETF, it is generally recommended to select one with a lower expense ratio, as this will save you money. However, it is important to note that some actively managed ETFs may have higher fees than passive ETFs. Actively managed ETFs have portfolio managers who actively make decisions about which securities to include in the portfolio, while passive ETFs simply track a stock index.

In addition to the expense ratio, it is also essential to consider other factors such as the fund's performance, holdings, trading volume, and commission costs. These factors can help you narrow down your options and make an informed decision about which ETF to invest in.

• Vanguard S&P 500 ETF (VOO)
• Schwab U.S. Mid-Cap ETF (SCHM)
• Vanguard Russell 2000 ETF (VTWO)
• Schwab International Equity ETF (SCHF)
• Invesco QQQ Trust (QQQ)
• Vanguard High-Dividend ETF (VYM)

Dividends and DRIPs

Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. Exchange-traded funds (ETFs) can also pay dividends to their shareholders if the underlying stocks in the fund's portfolio pay dividends. Dividends can be paid out as soon as they're received from each stock held in the fund, but most ETFs collect those dividends and distribute them every quarter.

ETF dividends can be reinvested either manually or through a dividend reinvestment plan (DRIP). A DRIP is 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 now widely available for ETFs, and most brokerages allow investors to set up a DRIP for any ETF that pays dividends.

DRIPs offer greater convenience and an easy way to grow your investments. They are also commission-free, making them an efficient way to grow your investment portfolio over time. With a DRIP, you can take advantage of compounding growth, potentially increasing your returns over the long term.

One disadvantage of automatic dividend reinvestments is that investors lose the ability to time the market. Manual dividend reinvestment, on the other hand, is less convenient but provides more control. It also allows investors to choose to invest the dividends in a different security rather than the ETF that issued them.

When deciding whether to enrol in a DRIP, investors should consider their investment goals and preferences. If they prefer a more hands-off approach and want to take advantage of compounding growth, a DRIP may be a good option. However, if they want more control over the timing of their reinvestments or wish to invest the dividends in other securities, manual reinvestment may be a better choice.

It's important to note that dividend reinvestments, whether through a DRIP or manual reinvestment, are typically taxable. Investors should consult with a tax advisor to understand the tax implications of reinvesting dividends.

ETF taxes

When it comes to taxes, ETFs are generally considered more tax-efficient than mutual funds. This is mainly due to their passive management style and the way they create and redeem shares, resulting in fewer taxable events for investors. However, it's important to note that different types of ETFs have different tax implications, and certain ETF trades may be subject to the wash sale rule.

Tax Efficiency of ETFs

ETFs are known for their tax efficiency, particularly passively managed equity ETFs. This is because they tend not to distribute a lot of capital gains, as they typically only rebalance their holdings when the underlying index changes its constituent stocks. In contrast, mutual funds, which are more likely to be actively managed, often trade assets more frequently, triggering capital gains taxes for their investors.

Taxable Events for ETFs

Selling an ETF is a taxable event, and the tax implications depend on how long you've held the ETF and your income. If you sell an ETF that you've held for more than a year, you'll typically pay long-term capital gains taxes, which can be up to 23.8% (including the Net Investment Income Tax, or NIIT) for high earners. On the other hand, if you hold the ETF for less than a year, you'll be taxed at the ordinary income rate, which can be up to 40.8%.

Dividends and Interest from ETFs

ETFs that hold dividend-paying stocks will distribute those earnings to shareholders, and these dividends are generally taxed as ordinary income. However, if you've held the ETF for more than 60 days before the dividend is issued, the dividend may be considered a "qualified dividend" and taxed at a lower rate, ranging from 0% to 20% depending on your income tax rate.

Special Cases: Commodity, Currency, and Precious Metals ETFs

ETFs that invest in commodities, currencies, and precious metals have unique tax treatments. Commodity ETFs that use futures contracts may be structured as limited partnerships, requiring investors to report their income on Schedule K-1 instead of Form 1099. Additionally, gains and losses on these ETFs are taxed using the 60/40 rule, where 60% is treated as long-term gains and 40% as short-term gains, regardless of the holding period.

Precious metals ETFs, such as those backed by physical gold or silver, are treated as investments in collectibles by the IRS. As a result, they are subject to a maximum long-term capital gains rate of 31.8% (including NIIT) and short-term gains are taxed as ordinary income.

Currency ETFs also have varying tax treatments depending on their structure. Those structured as open-end funds are taxed at the long-term or short-term capital gains rates, while those structured as grantor trusts are always taxed as ordinary income, and those structured as limited partnerships use the 60/40 rule.

Wash Sale Rule

It's important to note that if you sell an ETF and buy the same or a "substantially identical" ETF within 30 days, you may be subject to the wash sale rule. This means you won't be able to offset other capital gains with the loss from the sale of the ETF.

Tax Strategies with ETFs

One tax strategy with ETFs is to sell those with losses before their one-year anniversary to take advantage of the short-term capital loss treatment. Conversely, holding ETFs with gains past the one-year mark allows you to benefit from the lower long-term capital gains tax rates. Additionally, you can use ETFs for tax-loss harvesting by selling an ETF in a sector that has declined and buying another similar but different ETF to maintain exposure to that sector.

Frequently asked questions