Because of the tax problems inherent in mutual fund investments and out of demand for mutual funds with daily trading capability, a new type of fund has been created called an “exchange-traded fund.”
Mutual funds price all of the securities within a mutual fund portfolio at 4:00 p.m. everyday, while ordinary securities listed on an exchange price throughout a day. This means that a mutual fund investor cannot trade the shares of a mutual fund during the day. There is no market or pricing mechanism to allow the shareholder to share in any appreciation in a mutual fund’s price during the day in the same way a shareholder could, for example, buy IBM stock at one price when the market opens and another price during the day.
As long-term investors, we really don’t care much about our inability to trade mutual funds during any day. But, taxes are another concern that could be important to you.
Exchange-traded funds or ETFs are securities traded on an exchange (primarily the American Stock Exchange, but also the New York Stock Exchange) like any security, but they represent securities backed by portfolios. ETFs today are primarily representative of various indexes or market sectors. ETFs are available today based on over 80 different domestic and foreign indexes and sectors. You can buy an ETF based on the S&P 500, or a pharmaceutical index, for example.
How are ETF’s structured? An ETF looks and acts like a stock, such as a share of IBM. You can buy and sell IBM stock all day long and ETFs can be bought and sold throughout the day on the American and the New York Stock Exchanges. If you wanted to buy a share of the S&P 500 index, you could buy the ETF that represents the index or an index mutual fund that tracks the S&P 500. With an ETF, you can trade the S&P 500 throughout the day since ETFs are priced like any security. With an index fund, you can’t trade intraday.
With an ETF, there are no mandatory capital gains distributions and taxes you must incur annually—the capital gains you may have on an ETF are the same as if you owned IBM stock—you will be taxed when you sell the ETF and any gains you incur after holding the security for more than one year will be taxed at the capital gains rate. With ETFs, then, you manage your tax situation—you aren’t forced to incur the tax as you are with ordinary mutual funds, including index funds.
But, ETFs offer something more. Since they are based on index funds, ETFs are less expensive than managed mutual funds and even less expensive than index mutual funds.
Also, ETFs can be used to “short” an index. If you think an index like the S&P 500 will decline over time, you can “short” the ETF for the S&P 500. This means you enter an order to sell the ETF 500, even though you don’t own it. A settlement for any security takes three days—on the third day you will be required to deliver the number of shares you sold. You hope the market price of the ETF declines during that three-day period so that by the time you buy the shares to deliver you will be paying less money than you received when you sold the shares, thus making a profit.
Ordinary securities can be sold short and so can ETFs. Shorting a security is a trading concept, but what we’ve been discussing in these articles is making long-term investments as your strategy, not shorting securities and engaging in other daily trading to make money.
Many people feel that ETFs are only useful in trading securities. I think this is incorrect.
There is a use for ETFs in the portfolios of longer-term investors. If you have decided to set aside certain monies for the purchase of securities representing a certain market sector and you are unsure about what to purchase, you can buy ETFs that represent that sector. This will give you diversification in your portfolio until such time as you have decided what to buy or you can retain the ETFs to round out your portfolio.
About the Author: Lyn Striegel is an attorney in private practice in Chesapeake Beach and Annapolis. Lyn has over thirty years experience in the fields of estate and financial planning and is the author of “Live Secure: Estate and Financial Planning for Women and the Men Who Love Them (2011 ed.).” Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel.