What Are
Exchange-traded Funds and How Do They Work?
An
exchange-traded fund (ETF) is a basket of securities created to track as
closely as possible a particular market index, such as the Standard &
Poor’s 500 Index or the Dow Jones Industrial Average. They’re similar
to mutual funds in that they represent investments in the same types of
securities, but they generally have lower fees and can be bought and sold
with more pricing immediacy than mutual funds. They also have some clear
tax advantages.
Since their launch
in the early 1990s on the American Stock Exchange, there are now hundreds
of ETFs available for investors to buy. As the market has struggled its
way back since 2000, investors have embraced ETFs as a more efficient
alternative to a mutual fund invested in the same securities. A financial
planner can tell you whether ETFs are right for your portfolio, but here
are some details to know beforehand:
How are ETFs
created? An ETF is
created by large institutional investors who buy stocks aligning with the
shares in a particular index, and then they exchange those shares – in
baskets as large as 50,000 shares – for shares in the ETF. The
redemption process works the same way in reverse -- the institutional
investors exchange shares of the ETF for baskets of the underlying stocks.
Are all ETFs based
on indexes? Yes. Indexes,
like the S&P 500 or the Hang Seng Index (the primary stock index of
the Hong Kong Stock Exchange), are a listing of stocks reflecting the
activity of a particular investment sector on a stock exchange. One of the
first popular ETFs had an unusual nickname – Spiders – a play on its
actual name, SPDR, short for Standard and Poor’s Depositary Receipts.
Newer ETFs track less well-known indexes, even indexes of bonds, and some
ETFs are tracking very dynamic indexes that almost act like actively
managed funds.
How are ETFs traded?
Unlike mutual funds, which have their prices set at the end of the trading
day, ETFs are priced and traded every moment of the trading day. That’s
generally more meaningful to institutional investors who buy and sell
constantly than long-term investors who buy and hold. Furthermore,
unlike mutual funds, ETFs can be bought on margin or sold short.
Why might ETFs be
more tax-efficient?
Generally, ETFs generate fewer capital gains due to the unique creation
and redemption process as well as the usually lower turnover of securities
that comprise their underlying portfolios. Financial planners note that
investors can better control the timing of the tax treatment of ETFs
relative to mutual funds. Most importantly -- by holding an ETF for at
least one year and a day, capital gains will be treated as long-term
capital gains, which are currently taxed at a federal rate of 15 percent
(5 percent for low tax bracket investors).
Are there other
advantages? Unlike
traditional mutual funds, which must disclose their holdings quarterly,
ETF holdings are fully transparent, and investors know what holdings are
in the ETF at any given time. Each ETF also has a NAV tracking symbol for
even more precise analysis. This helps keep ETFs trading within pennies of
their intraday NAV.
What about fees? Shares
of index-based ETFs may have even lower annual expenses than similar index
mutual funds, which, in turn, tend to be lower than those of actively
managed mutual funds. ETFs must, however, be bought and sold through
brokers, and those trades do involve transaction costs. ETFs may prove to
be more expensive than mutual funds to investors who add money each month
to their portfolio.
What’s the downside? 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 supply and demand for the ETF shares alone. Usually, the
ETF value closely mirrors the value of the underlying shares, but there’s
always a chance for ETFs to trade at prices above or below the value of
their underlying portfolios. Also, since so many new ETFs are hitting the
market, investors should be aware of the maturity of the particular ETF
they are considering.
April 2007— This column is
produced by the Financial Planning Association, the membership
organization for the financial planning community, and is provided by
McGuire & Co., LLC, a local member of the FPA.
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