What are exchange-traded funds (ETFs)?
Exchange-traded funds (ETFs) are an emerging class of low-cost index funds that trade like stocks. In the U.S., ETFs can be found on the American Stock Exchange, the NYSE Arca, or the NASDAQ.
What's the history behind ETFs?
The history of exchange-traded funds dates back to 1993, when American Stock Exchange launched the "Spiders", also known as the S&P Depositary Receipts, Trust Series 1. The underlying index tracks the S&P 500. Other well-known ETFs followed, with the Diamonds (tracks the Dow Jones Industrial Average) being introduced in 1998 and the Cubes (tracks the NASDAQ 100) launching in 1999.
How do I buy or sell ETFs?
ETFs are listed and traded with ticker symbols, the same way as individual stocks. They can be bought or sold through a full service or discount broker/dealer. A brokerage commission to buy or sell will usually apply.
What's the typical cost of an ETF?
There are a number of factors that affect the cost of an ETF, including the expense ratio and the brokerage commission to acquire the fund. Generally, the expense ratios of ETFs are consistently lower versus actively managed mutual funds. Also, expense ratios will vary among ETF companies, but this information can be obtained from the fund prospectus.
How liquid are ETFs?
The liquidity of an ETF is mainly affected by the liquidity of the underlying stocks or bonds in its index - not the trading volume of the fund itself. The reason is because it's less complicated for authorized participants or market makers to assemble creation units for liquid stocks or bonds. (Creation units are baskets of underlying stocks or bonds within an ETF that can be exchanged for ETF shares.) It's possible for ETFs with low trading volume to still be liquid.
Do ETFs pay dividend income?
The dividend income received from underlying stocks or bonds in an ETF's portfolio are distributed to fund shareholders. The frequency of dividend payments can be quarterly or monthly, depending on the fund. Many bond ETFs pay out dividends monthly.
What indexes do ETFs track?
Exchange-traded funds track the performance of a variety of broad based and narrow stock, bond, currency and commodity indexes.
Are exchange-traded funds listed in the newspaper?
Some papers list ETFs near the stock tables or under the stock exchange where the fund is listed. This is the general approach most newspapers take. The Wall Street Journal has a section listed under "Exchange-Traded Portfolios".
What market risks are associated with ETFs?
Equity-based exchange traded funds have a similar risk profile to those of stocks, while fixed income-based ETFs have a risk profile that matches bonds. Performance returns will fluctuate and are subject to market volatility. ETF shares may be valued more or valued less than their original cost at the time of sale. ETFs are not FDIC insured, past performance is not a guarantee of future results, and other pertinent risk information can be located in the fund prospectus.
What's the difference between the market price and NAV an ETF?
Net Asset Value (NAV) refers to a fund's total assets minus its liabilities, whereas market price refers to the quoted price that an ETF is trading at on an exchange. While large premiums/discounts are rare, at times the NAV and market price of ETFs will diverge.
ETFs vs. Mutual Funds
Are mutual funds better than ETFs?
Not necessarily. Each financial product has its strengths and weaknesses. Any fair comparison should be done in the context of not just performance, but tax efficiency, fees/total ownership costs, risks, structural differences of each product and if the fund objectives match the financial objective(s) of a particular investor. Always refer to a prospectus for detailed information before investing.
Are mutual funds less risky to own than exchange traded funds?
Not necessarily. ETFs, like mutual funds, come in a variety of shapes and sizes. The level of risk in an ETF or mutual fund is often determined by the portfolio holdings within the fund. Both mutual funds and ETFs can track a variety of indexes and sectors. Some indexes or sectors will be more risky and volatile than others. However, there's no substantiated research to prove that ETFs are any more or less risky compared to mutual funds.
How are mutual funds and ETFs different?
ETFs offer investors intraday liquidity and are bought and sold with a brokerage account. Mutual funds are priced at the end of the day and cannot be bought or sold during regular trading hours. Also, ETFs are traded on a stock exchange, whereas mutual funds are bought and sold directly with the fund company or through a mutual fund trading platform.
How does the cost of mutual funds compare to ETFs?
Generally, investors buying or selling ETFs will pay a transaction commission to a broker, whereas investors buying or selling no-load mutual funds directly from a fund company pay none. However, some brokers impose a commission to buy or sell no-load mutual funds. Other so-called "no transaction fee" mutual funds don't charge a commission to buy, but often carry higher expense ratios. Also, ETFs do not impose back end redemption charges like many mutual funds.
Ultimately, any fair cost analysis between ETFs and mutual funds should look at the total spectrum of expenses - not just the transaction fee to acquire the ETF or mutual fund. Pay close attention to the expense ratio, portfolio turnover, and tax efficiency of a mutual fund versus an ETF. Always refer to a prospectus for detailed information before investing.
ETFs vs. Exchange-traded notes (ETNs)
How are ETFs different from ETNs?
ETNs are not registered or organized the same as traditional ETFs, but are debt instruments. As such, ETNs carry issuer credit risk whereas ETFs do not. ETNs typically have a maturity date and pay a return linked to the performance of a market index. They have investment management fees and are traded in the secondary market just like ETFs.
What are the risks of ETNs?
As debt securities, ETNs carry issuer credit risk. This means that investors should pay close attention to the financial ratings and stability of the ETN issuer. Another element of risk is taxation. The IRS could change the tax rules affecting ETNs.
What are the advantages of ETNs?
ETNs linked to commodities and stocks generally have a high level of tax efficiency. Also, ETNs do not have tracking error, which happens when a fund's performance deviates from the underlying index it follows.
ETFs vs. Stocks
How are individual stocks different from ETFs?
While ETFs and individual stocks often trade along side one another on stock exchanges, they are not the same. ETFs are generally more diversified, since they are composed of groups or baskets of stocks, bonds, or commodities. Also, ETFs track specific indexes whereas individual stocks don't.
How are individual stocks similar to ETFs?
Like individual stocks, ETFs can be leveraged with margin, shorted, or bought and held. Also, both are listed and traded on stock exchanges.
Are individual stocks better than ETFs?
Not necessarily. Each has its strengths and weaknesses. Any fair comparison should be done in the context of not just performance, but tax efficiency, fees/total ownership costs, risks, and if the fund or stock objectives match the financial objective(s) of a particular investor. Always refer to a prospectus for detailed information before investing.
ETFs vs. Closed End Funds
How are ETFs and closed-end funds different?
Since ETFs are index funds, they generally trade closer to their net asset value (NAV). In contrast, closed-end funds are usually actively managed and often employ leverage. This makes it more likely that a closed-end fund will trade at a premium or discount its NAV, due to supply and demand of the fund's shares.
How are ETFs and closed-end funds similar?
Both ETFs and closed-end funds are listed and traded with ticker symbols on a stock exchange. Investing in both will usually result in brokerage commissions. Information on specific fees, charges, and expenses is obtained in the fund prospectus.
How does the cost of closed-end funds compare to ETFs?
The expense ratios of ETFs are generally lower versus closed-end funds. Since ETFs are indexed portfolios, the cost of managing them is less compared to actively managed portfolios. Investing in both ETFs and closed-end funds will usually result in brokerage commissions. Information on specific fees, charges, and expenses is obtained in the fund prospectus.
ETFs and Taxes
How are ETFs taxed?
ETFs are required to distribute dividends and capital gains to shareholders. This is usually done at the end of each year and these distributions can be caused by index rebalancing, diversification rules, or other factors. Also, anytime you sell your fund this could generate tax consequences. Consult your tax advisor for more specific info/advice.
How is dividend income from ETFs taxed?
ETFs, like mutual funds, are required to distribute dividends to shareholders. Dividends are taxable as income to the shareholder, unless you own the ETF in a retirement account.
The Tax Relief Reconciliation Act of 2003 reduced the maximum tax rate on dividends from 35% to 15% for most investors. The rule also applies to dividend distributions paid to ETF shareholders. The dividend income from REIT ETFs may not be subject to the lower tax rate, although the capital-gains component of dividend income applies under the lower tax. Consult your tax advisor for more specific advice.
What are the tax advantages of ETFs?
Most ETFs are designed to track set benchmarks, which translates into fewer trades and lower portfolio turnover. This reduces the frequency of tax gain distributions. By comparison, actively managed portfolios generally have higher turnover, which can translate into untimely or more frequent tax distributions.
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