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Exchange-traded funds: Everything you need to know about ETFs

At a glance:

  • What are ETFs?

  • How do ETFs work?

  • The pros of ETFs

  • The cons of ETFs

  • How to decide if ETFs are for you

  • Summary of ETFs

They're part mutual fund. They're part stock. And their numbers seem to keep growing and growing.

"They" are exchange-traded funds (ETFs). They've been around for years, but as giant asset managers, such as Barclays Global Investors (iShares) and Vanguard, roll out scores of new offerings, ETFs have become a viable option for today's investor.

In this course, we'll discuss how ETFs differ from regular mutual funds, what their advantages and disadvantages are, and how to determine whether they might be appropriate for you.

What are ETFs?

Like mutual funds, exchange-traded funds (ETFs) are baskets of securities. Like stocks, ETFs trade on an exchange. Unlike regular mutual funds, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin. Anything you might do with a stock, you can do with an ETF.

What kinds of ETFs are out there?

There are a number of different equity ETFs on the market, including SPDRs, Select Sector SPDRs, MidCap SPDRs, and DIAMONDS. ETFs have also branched out into the bond arena with scores of bond ETFs now on the market. ETFs also come in more-exotic flavors.

While conventional mutual funds still vastly outnumber ETFs; funds that drill down into specific sectors, industries, regions, countries, and asset classes make up a greater percentage of the ETF universe, offering relatively inexpensive access to investments such as currencies, precious metals or emergent industries that heretofore have been the sole province of larger institutional and wealthy investors.

About management

ETFs are largely passively managed, which means that each tracks a sector-specific, country-specific, broad-market, or other index. A manager isn't actively choosing which stocks to buy and sell.

Why indexing?

Why has indexing been the strategy of choice for ETFs? ETFs rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. So, many ETFs have chosen the indexed route because active managers rarely disclose their portfolio holdings more frequently than the Securities and Exchange Commission requires (which currently is four times a year).

Although ETFs are largely index-based, more actively managed or enhanced-index ETFs are gaining visibility. For example, the WisdomTree ETFs follow indexes that are weighted based upon stock dividend metrics rather than a more-traditional market-cap weighting. WisdomTree's research shows that a dividend weighting has provided stronger returns in the past, but the jury's still out on future performance.

Actively managed ETFs on the horizon?

In addition, actively managed ETFs are a new innovation, but they still have much to prove to regulators, money managers, and investors about their portfolio transparency, fee structures, and real-world operations before they'd become widely available.

How do ETFs work?

Exchange-traded funds cannot be bought from or sold back to the fund company like regular mutual funds.

Investors can only buy or redeem shares directly from the sponsoring fund company in blocks (typically 50,000 shares), and even then, the funds require in-kind transactions. With an in-kind transaction, you don't get cash when you redeem your shares; you get the underlying stocks. In practice, this means that only institutions and the very wealthy can afford to deal directly with the fund companies. The rest of us have to go through a broker to buy and sell shares.

How trading relates to the net asset value

Unlike regular mutual funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, the market price of an ETF is determined by forces of supply and demand for the ETF shares.

To a large extent, the supply and demand for ETF shares are driven by the underlying values of their portfolios, but other factors can and do affect their market prices. As a result, the potential exists for ETFs to trade at prices above or below the value of their underlying portfolios.

However, by permitting large investors to buy or redeem shares in-kind, the fund companies behind ETFs have created a mechanism that should, in theory, help prevent sustained price-to-NAV discrepancies from opening up.

If an ETF traded at a discount to its net asset value, institutional investors could assemble 50,000-share blocks in the open market at the discounted price, redeem them for the underlying stocks, and sell those stocks at a profit. The actual transaction isn't quite that simple, but the idea is the same: The arbitrage opportunity would generate sufficient demand for the discounted ETF shares to close the gap between their market price and the net asset value of the underlying portfolio.

The pros of ETFs

Exchange-traded funds have several clear advantages over traditional mutual funds.

ETFs offer more flexibility

ETFs trade throughout the day, so you can buy and sell them when you want. When you buy a mutual fund, in contrast, you're buying at the end-of-day net asset value, no matter what time of day you place your order.

The annual expenses of ETFs are considerably lower than most mutual funds'

SPDRs (SPY) and the iShares S&P 500 Index (IVV), for example, range from 0.03% to 0.11%. If you are considering an index mutual fund, it's worth investigating to see if an ETF follows the same index. The ETF's expense ratio could be cheaper.

Because of their structure, ETFs should be more tax-friendly than mutual funds

With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital-gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions. Furthermore, redemptions made by large investors are paid in-kind, again protecting shareholders from taxable events.

All of this should make ETFs more tax-efficient than most mutual funds, and they may therefore hold a special attraction for investors in taxable accounts. Keep in mind, however, that ETFs can and do make capital-gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying indexes.

The cons of ETFs

These new investment options have their limitations, too.

The arbitrage mechanism keeping prices in line with NAVs isn't fail-safe

Heavily traded issues such as SPDRs, which track the S&P 500, and PowerShares QQQ (QQQ), which tracks the Nasdaq 100, should trade right around the value of their underlying securities. But there can be a difference between an ETF's price and the net asset value of its portfolio, especially for those ETFs that aren't traded frequently.

Moreover, it is not yet known how ETFs might behave in the face of a full-fledged market correction. It's conceivable that investors wishing to sell ETFs in the midst of such an event would have to sell their shares at prices below that of the ETF's net asset value.

You may have to pay a commission to buy an ETF

The expense advantage of ETFs may also prove to be more mirage than fact for most investors. That's because you must pay commissions to buy and sell ETFs, whereas a no-load mutual fund can be bought directly from the fund company, or a no-transaction-fee fund from a brokerage, for no sales charge.

If you plan on making a single, lump-sum investment, then it may pay to choose an ETF. However, even assuming a low commission of $8 per trade, a single lump-sum investment of $10,000 in the iShares S&P 500 Index would need to be held for nearly two years to beat Vanguard 500 Index's (VFINX) costs, assuming you purchased the Vanguard fund without a transaction fee.

ETFs' low expenses are touted as one of their key benefits, but the fact remains that if, like most of us, you invest regular sums of money, you'll actually end up costing yourself far more with an ETF than you would with many mutual funds. Also, for the same reason, investors who wish to trade frequently would be much better off from a cost perspective with a regular mutual fund than with an ETF.

How to decide if ETFs are for you

To figure out whether an ETF or fund might be better for your situation, let's take an example. Say you have $5,000 to invest. You plan to add $50 to the investment every month and hold this investment for at least 10 years.

Here's an example to follow

You can enter the following information into an online tool that estimates expenses and returns, so you can identify the best fund for you. The following example uses Morningstar.com's Cost Analyzer tool.

  • Initial investment = $5,000.

  • Monthly investment = $50.

  • Expected return = 10%.

  • Time horizon = 10 years.

  • We entered the tickers for ABC 500 Index mutual fund and the SPDRs ETF.

  • Check with your broker to determine what transaction fees may apply, but for the sake of this example, we assume there's no commission to buy the ABC 500 Index, but we had to pay an $8 commission when we bought the SPDR. So we entered $8 under "Commission $" for the SPDR.

  • We showed the comparison.

In this case, the calculator indicates a final value of $22,629.25 for the ABC fund, and $21,193.21 for the ETF, due to the extra cost involved with monthly ETF trading commissions, which outweighed the ETF's expense advantage over the ABC fund in this scenario.

Before making your decision, we recommend changing the inputs to reflect a different time horizon, investment amount, expected return, etc., and see if the results change.

Do ETFs perform better?

This is the ultimate question, isn't it?

Theoretically, ETFs should perform better than similar mutual funds. Because investors do not buy or sell shares directly from the ETF, ETFs shouldn't suffer from having to keep cash on hand to meet redemptions, or from being forced to sell stocks into a declining market for the same purpose. But not all index mutual funds and ETFs are created equal.

Summary of ETFs

ETFs have a lot to offer. They're flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading, which should make them more tax-efficient than many mutual funds.

Nevertheless, look carefully before you leap. ETFs' cost advantages aren't always as large as they might seem, and trading costs can quickly add up. Particularly if you're in the market for a fund that tracks a broad index such as the S&P 500, or if you wish to invest regular sums of money, the case for choosing an ETF over one of the existing low-cost mutual fund options isn't clear-cut.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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