Exchange-traded funds, or ETFs, are the backbone of many an investor. It’s a great tool to help build a new, well-diversified portfolio. It can also be a great way to add depth to an existing portfolio. However an ETF is used, it’s important to know the ins and outs of the strategy so it can be used with great effectiveness.
ETFs – Not a Mutual Fund
An ETF looks similar to a mutual fund. After all, it has an investment structure that pools investor assets, and it utilizes the skill of professional money managers to invest money to match client desires specifically. It even has a prospectus.
However, they are not the same. For one thing, it’s a relatively new strategy, as it was first developed within the last decade or so. There is also one fundamental difference between the two. An ETF investor will purchase the shares on a stock exchange in a process that look like a typical stock purchase. A mutual fund investor, on the other hand, purchases or redeems from the fund directly. The creation of an ETF is also cashless, something that is radically different than that of mutual funds.
How an ETF Operates
ETFs are built through the creation of security certificates, which are typically developed and managed by the largest money management firms in the country. The managers create the plan with enough clout to purchase 10,000 to 50,000 shares of the ETF. These shares are sent to a specific custodial bank, which then forwards the shares to the market maker to keep it safe.
When it’s time to redeem the shares, the manager buys a healthy chunk of the ETFs, forwards them to the bank, and receives an equal amount of individual stocks. Once this happens, the stocks can then be sold on a stock exchange, although they are typically returned to the place that loaned the shares.
Buying and Selling ETFs
Because ETFs are built to act as a stock purchase, investors can treat them like a stock purchase. This allows them to enjoy continuous pricing, and it also enables them to be bought and sold throughout the day. As such, investors can place orders on them in the same manner as they could with individual stocks. These orders can include things like stop-loss orders, limit orders, or good-until-cancelled orders. ETFs can also be sold short.
An investor only needs to buy as little as one share. However, most choose to buy in board lots; that is, 100 shares. There’s a good reason for this – anything less than 100 shares bought will increase the cost to the investor. What’s more, there’s a global tinge to ETFs – anyone can pick one up no matter where it trades at in the world. This provides ETFs an advantage over their mutual fund counterparts, which can typically be purchased in the country where they’re registered.
ETFs pay out dividends received from stocks quarterly. However, these stocks pay dividends throughout the quarter, meaning the funds can hold cash for various times throughout the quarter, even when the stock benchmark index doesn’t consist of cash. If this cash winds up in your brokerage account, it’s up to you to make another purchase if you want to reinvest the funds.
The Tax Benefits of ETFs
ETFs are passively managed portfolios. What this means is, they are investing in index funds as opposed to actively managed funds. As such, they tend to provide greater tax benefits than regular mutual funds. They produce fewer capital gains because of low securities turnover, and they see fewer capital gains than actively managed funds. What’s more, and index ETFs only sells securities to reflect changes in the underlying index. This methodology manages to keep the taxes that would be associated with these funds down, thus giving a nice tax break to the investors.
Transparency and ETFs
Perhaps the most attractive component to ETFs for an investor is how transparent the process always is. Because ETFs are built to mimic the performance of their underlying commodity or index, investors will always have a bead on what they’re purchasing and how the ETF is built. The fees associate with the ETF are always laid out in an easy to follow basis. In other words, the ETF investor will know where their money is at all times. This may not be the case with mutual funds since they are only required to have their holdings reported twice a year.
ETFs and Cost Effectiveness
Another alluring aspect of ETFs is concerning their cost. This methodology is typically associated with low annual fees, especially when their price tag is compared to mutual funds. Several factors contribute to keeping the price tag lowered, including a reduced level of marketing, the passive nature of index investing, and distribution and accounting expenses.
With that being said, it should be noted that investor in ETF shares must pay a brokerage commission to buy and sell ETF shares. If you’re an investor that’s planning to trade ETFs on a frequent basis, this may induce a little bit of sticker shock. However, investors may also take heart in knowing that competition has driven down the cost of brokerage fees, so their bottom line won’t wreak as much havoc now as it may have back in the day.
The Shifting Look of ETFs
When ETFs first hit the scene, they were built to track broad market stock indexes. As they’ve grown, they’ve matured to a point where they can track a wide array of elements, including investment styles, global investments, fixed income, and more. In other words, ETFs can mimic virtually any index that’s out there.
This element of diversity is further joined by other options that further separate ETFs from their mutual fund counterparts, such as tax benefits and a greater level of transparency. When the entire package is viewed, it becomes clear that the stock of ETFs is only going to increase as more and more investors discover what they’re all about.