What are Exchange Traded Funds?

As their name suggests, exchange-traded funds (ETFs) are investment funds that trade openly on the stock exchange. Although they have become increasingly popular of late, ETFs have actually been around since the late 1970s.

ETFs are structured similarly to mutual funds in that each share that an investor purchases represents partial ownership of an underlying group of securities. Investors in both mutual funds and ETFs can achieve diversification through a single purchase. However, ETFs can be bought and sold on an exchange throughout the day, whereas mutual funds can be bought or redeemed from the mutual fund company only after the close of trading. Thus, ETFs combine the diversification potential of a broad portfolio with the simplicity of trading a single stock on an exchange.

The first ETF was designed to track the performance of the S&P 500. And the majority of ETFs on the market today stay true to their passive “indexing” heritage—tracking specific indexes in the attempt to “be” the market, rather than beating it.

However, in an effort to outperform the market, some managers create specific parameters, screens or weightings when selecting securities for their ETFs. For example:

  • A fund manager might start with the S&P 500 Index but choose only those stocks with the highest dividend yields.
  • Another manager may create a basket of securities to invest in assets not typically covered by an index—such as currencies.

These managers are, in effect, combining elements of active and passive investing by actively creating their portfolios, which are then more passively managed on a day-to-day basis.

ETFs differ most significantly from mutual funds in the way they are bought and sold. ETFs behave like stocks, and investors can buy or sell shares at any time throughout the day. Like stocks, ETFs also offer flexible trading options, such as stop and limit orders (a stop order sets a specific price at which ETF shares are to be purchased or sold, while a limit order sets a maximum or minimum price at which you are willing to buy or sell ETF shares, respectively) and the potential for such tactical hedging strategies as selling short (borrowing ETF shares to sell now in the hopes that you can buy them back more inexpensively later) or on margin (taking out a loan to buy ETF shares, or using ETF shares as collateral in an effort to leverage your existing portfolio beyond your initial investment).

Another potential advantage of ETFs is that, unlike many mutual funds, they typically have no sales charges. Plus, like most index funds, they generally offer low management fees. However, there are trading costs associated with an ETF, as there are for stocks. In many cases, low fees and expenses can outweigh trading costs, but this will depend on how frequently and in what quantity an investor trades.

ETFs offer a number of potential benefits that can make them extremely effective for helping investors reach specific long-term goals:

  • Diversification
  • Low fees and no sales load
  • Intraday liquidity
  • Tax efficiency
  • Transparency—and much more

ETFs come in every style and asset class in the investment rainbow. They can help investors generate income, achieve long-term growth, gain more complete diversification—and much more.

As the table below illustrates, ETFs offer a number of benefits that can make them extremely effective in helping investors reach specific long-term goals. Additionally, as with mutual funds, ETFs come in every style and asset class in the investment rainbow. They can be used to complement mutual funds in an existing asset allocation, to replace mutual funds—or for an entire portfolio.

ETFs vs. Mutual Funds

While ETFs and mutual funds share many commonalities, there are a few key differences that make ETFs advantageous to many investors. For example, ETFs offer intraday liquidity, as they are traded on most major stock exchanges and be purchased and/or sold throughout the day at whatever the current prevailing price.

Mutual funds on the other hand, can only be bought and sold at the end of the day based upon the Funds’ closing price. There is generally a commission cost associated with trading ETFs, while there is no transaction fee for no-load mutual funds. For ETFs, there is generally no minimum investment, while with mutual funds, there can be a set minimum. One big advantage that ETFs typically have over mutual funds is when it comes to taxes.

Mutual funds are required to pass through all gains and losses to existing shareholders at the end of each year. Thus, the gains and/or losses made when the fund sells securities during the year accumulate and the taxes on those gains are allocated to the current holders of those shares when the distribution is made. In most cases, the underlying securities transactions in an ETF are made through like-kind exchanges and thus do not generally accrue, or at least are able to mitigate taxable distributions. Endowment Wealth Management utilizes ETFs as the preferred investment vehicle for our clients.

Exchange-Traded Funds Mutual Funds
Bought and Sold On an exchange throughout the day Through the mutual fund companies
Sales Charges None, though ordinary brokerage commissions apply May have sales loads, purchase and/or redemption fees
Minimum Investments None, an investor can buy one share May have high minimum investments
Expense Ratios Traditionally low Dependent on Management styles
Liquidity Intraday End of the day
  • Ability to trade intraday
  • Special trading orders are possible:-Market: ETF shares are bought or sold at the market’s current price at the time of execution
    -Stop: sets a specific price at which an ETF is to be purchased or sold
    -Limit: sets the maximum and minimum price, respectively, at which you are willing to buy or sell shares of an ETF
    -Short selling: borrowing ETF shares to sell now in the hopes of buying them back more inexpensively later and profit from the difference
    -Margin trading: taking out a loan to buy ETF shares, or using ETF shares as collateral in an effort to leverage your existing portfolio beyond your initial investment
  • Trades only executed once per day
  • Special trading not possible
  • Trading frequency restricted
Consequences of purchases and sales
Security prices
Tax implications
Purchases and sales of shares on the secondary market generally:

  • Do not affect security prices
  • Do not impact tax efficiency
  • Do not trigger capital gains or losses on the underlying securities
Purchases and redemptions of a large number of shares can:

  • Impact the underlying security prices as the fund buys or sells shares
  • Impact the fund’s NAV and returns
  • Trigger capital gains or losses on the underlying securities
  • Affect the fund’s tax efficiency
Transparency Fund holdings published daily Fund holdings typically published quarterly
Portfolio Investments Assets are typically fully invested as there is no need to hold cash aside for redemptions Mutual funds typically hold at least 5% of their assets in cash in order to handle day-to-day redemptions

(Source: WisdomTree)

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