Why Choose an Exchange-Traded Fund (ETF)


ETF funds are primarily an index fund (mutual funds which track indexes of the stock market) but still they trade just like stocks do.

A person can’t avoid capital gains, but an investor won’t pay capital gains on their ETF shares until the final sale. ETFs can cost the investor less money in taxes.

Every time they sell or buy shares buyers pay a brokerage commission because ETF’s trade like stocks.

They have most of the benefits of index funds but with some benefits. The fees for ETFs are often cheaper than the index funds, and most likely will cost you less in taxes.

They calculate an ETF’s underlying net asset value by taking the current value of the fund’s net assets (the value of all securities minus liabilities) then divide by total number of outstanding shares. The net asset value, called the NAV, is then published every 15 seconds through the trading day. But the ETF’s Net Asset Value is not actually its market price.

When someone purchases shares of a mutual fund- it’s the price at which shares are bought or sold from the fund. The NAV is set at the end of each trading day at a traditional fund.

ETFs work differently. Since ETF funds trade similar to a stock, a person can buy and sell shares on a stock exchange for a price which is determined by demand and supply. This is the reason an ETF’s market price can be different than its net asset value. The process by which ETF shares are configured works to keep the gap between these two figures on the tight side.

During the past five years funds invested in ETFs have quintupled. The amount of ETF funds have dramatically increased at a similar pace. There are hundreds of ETF funds to choose from.

Investors like ETFs for various reasons:

Costs: Compared to the mutual funds, well managed ETF funds have very low management fees.

Taxes: At tax time ETFs are big winners. Similar to an index fund, the ETF manager doesn’t have to buy and sell stocks frequently until a component of the related index the ETF is tracking has changed. (This happens when companies merge, go out of business, or if their stocks move up or down). ETF’s are usually more tax-efficient than mutual funds pursuant to the special way ETFs are structured.

Diversification: Similar to index funds, an ETF offers an efficient form of investing in a particular section of the stock or bond market (energy or emerging markets, small caps), or the complete market ( the S & P 500).

Open Book: Since they track the underlying index, you know what stocks are held in the ETF. With a normal mutual fund, asset holdings are only revealed after a long delay and a few times through the year.

User-Friendliness: ETF funds can be sold or bought any time across the day. Conversely, Mutual Funds are priced at the end of each trading day, and only once in the day. An investor can usually trade out of an ETF any time during the day which is a good feeling to have.

There is a small drawback. As ETFs trade similar to stocks, a brokerage commission has to be paid every time an investor buys or sells shares. (Online brokerage commissions range from a few dollars per trade to $20 per trade). Lump-sum investors favor ETF funds, but it may be better to use a traditional index fund if you buy a little bit here and there, to avoid all those commission charges.

When should one buy an ETF? ETFs come in handy if: • When one has a chunk of money to invest – like when one rolls money from a 401(k) to an IRA account- An ETF fund may be a smarter choice.

If you desire to regularly add to your investment each month, some think it’s better to stick to a mutual fund which allows you to buy in [without] paying a brokerage fee. Paying a broker commission on each trade will reduce your returns. There are a dozen decent mutual funds to choose that track the larger stock indexes.

One can use an ETF fund for an alternative if you don’t have the $2,000 minimum investment usually required by various mutual funds. With just three ETFs one can create a reasonable portfolio. ETFs can track and perform the same as stocks. In many ETFs you can buy option contracts, and they can also be bought on margin or shorted, just like stocks. Note: One should leave these trades to the professionals, we don’t advise for a novice to try this.

Where to purchase an ETF: Almost anywhere you can buy a stock you can buy an ETF fund. They can be bought via a broker or a brokerage account. We think your best option is with an online broker who charges lower commissions. Compare Fidelity, E*Trade, or Charles Schwab prices to trade.

Be sure they offer all you’re looking for before you commit to one brokerage firm. Smaller funds may only provide a brief selection of ETFs – when they should offer the most widely-used, popular and easy to trade funds.

An investor should ask questions like: How is the fund constructed, what does the index track, what is held inside and how long has it existed?

Before you invest, consider the costs. You can see what an ETF costs via an expense ratio. That amount is deducted from your account and will go to pay a fund’s total expenses. And always remember, the expense ratio will not include the broker commission you have to pay to sell or buy shares of an ETF.

You’ll find an expense ratio of 0.44% for the average ETF. This translates to costing you $4.40 in annual fees for every $1,000 invested. According to Morningstar Investment Research, the average index fund should cost 0.74

Life-cycle funds: Are also called target-dated retirement funds. They invest in a combination of bonds and stock funds which mix gradually gets more conservative as the investor nears retirement. Be sure to check to see if they charge an [extra] fee for management. It might be a better deal to be in a target-dated fund that invests in regular index funds and [doesn’t] charge this extra fee. Be sure to make a true comparison.

Always compare any tax consequences for your investment. Because of the special way they are structured most ETFs are pretty tax efficient. These funds might trigger higher capital gains costs.

The ETFs invested in precious metals, such as silver or gold, are designated “collectibles” and are taxed at a much higher rate by the IRS. Gains on ‘collectibles’ are now taxed at a maximum rate of 28%, as opposed to the long-term capital gains rate of 15%. (2013)

Don’t ever forget that a trade in or out of ETF shares will create a taxable gain, the same as stocks.

One should know the primary players and nicknames used. ETF providers name their ETF funds different trade names.

Barclays PLC calls their ETF fund as iShares. • SPDRs is what State Street Corp. calls their products (pronounced spiders). • Vanguard Group, named theirs Vanguard ETFs.

Good luck and good investing.