What is an ETF?

From FinancialPlanning

1 General
2 Advantages
3 Disadvantages
4 Sources of additional Information
5 Footnotes

General

An ETF is an Exchange-Traded Fund, a special type of mutual fund purchased through a brokerage account. You buy and sell ETFs the same way you would a common stock, placing market or limit orders for a given number of shares. Just as with an open-ended mutual fund, each share represents a proportional ownership stake in a basket of securities. Most ETFs are based on stock indices such as the S&P 500 or Russell 2000, but ETFs are now offered in virtually every asset class, including international stocks, REITs, bonds and commodities.

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Advantages

ETFs offer some advantages over traditional, open-ended mutual funds, that may be of interest to the typical MIFP investor:

Mid-day Trading ETFs may be bought and sold throughout the day, unlike traditional mutual funds, which trade at the end of the day based on closing NAV. You can purchase or sell the fund at a known price, rather than placing the order during the day and waiting to see what the closing price will be. With volatile investments it's not uncommon to see daily price fluctuations within a +/-1.5% range and some investors prefer buying or selling at a known price rather than face the risk of an end-of-the-day price shift.

Taxes ETFs may be more tax-efficient than an otherwise equivalent mutual fund, because they have a mechanism for reducing (or even eliminating) capital gains distributions. An ETF prospectus will describe this in detail, and it's summarized in the footnote below. <ref>In a typical mutual fund, selling of stock by the fund managers leads to capital gains that are distributed to shareholders -- who are taxed on those gains, if the fund is held in a taxable account. This happens even in relatively low-turnover index funds, because of changes to the indices. In the ETF, the custodian can distribute "gain" shares of stock during the process of redeeming ETF shares (for example, to an institutional trader who is doing arbitrage trading), and leave behind shares that have a higher cost basis. This means that capital gains distributions can be reduced or eliminated. Most of the iShares, for example, had minimal or zero distributed capital gains during 2005, even with asset classes where the corresponding index fund paid a distribution.</ref>

Costs The management fees for ETFs are very low -- usually lower than comparable mutual funds. Some of the iShares, for example, have fees as low as 0.08% per year, vs. 0.20% for a similar mutual fund from The Vanguard Group.

Shorting Shorting doesn't appear to be a commonly used strategy among MIFP readers, but this is usually mentioned as an advantage of ETFs...you can short them (borrow shares and sell them, hoping to buy replacements at a lower price in the future).

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Disadvantages

ETFs have some disadvantages as well:

Discounts/premiums Unlike open-ended mutual funds, ETFs do not trade at NAV. You'll pay a slight mark-up when buying, and lose a bit when selling (this price difference is called the "spread"). With larger ETFs the spread is very small, but it can be noticeable for less frequently traded funds. The problem is not as great as it is with closed-end mutual funds, because arbitrage trading keeps ETF pricing relatively close to NAV.

Commission costs You'll pay a commission every time you buy or sell an ETF, so they're not good for smaller purchases. Compare a $500 per month investment in an ETF to one in a traditional open-ended mutual fund. The ETF purchase might incur a $10 (2%) commission, while the mutual fund is bought at no load. That 2% cost reduces returns by that amount, and is probably much more significant than the difference in expenses between the ETF and the mutual fund. The commission cost also comes into play when selling, and can be a factor even in a relatively large account (example: retiree who draws $500 per month from each of six mutual funds...very expensive using ETFs, because of commission costs).

Tax Rate for Dividends Some ETFs are traded so frequently, with shares created and redeemed so often, that the stocks are not held long enough for all of the dividends to qualify for the 15% tax rate that applies to qualified dividends. This could negate some of the potential tax advantages of the ETF structure.

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