What Are ETF’s?

Three U.S. economists recently won the Nobel Prize for Economics for their work disputing the “efficient market theory.” Without going into more detail, there is an investment in widespread use today that solves some of the inefficiencies of mutual funds.

What are those inefficiencies? First, a lack of liquidity; second, tax issues and third, poor mutual fund management.

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.

More importantly, a mutual fund may have a great deal of trading occur within it and such trading can produce capital gains that by law must be distributed to the fund shareholders at least annually. When a mutual fund portfolio manager sells a stock at a profit, the fund incurs a capital gain that must be passed to the shareholders of the fund. Suppose the mutual fund trades a lot of securities and incurs a large capital gain while at the same time it performs poorly and loses money? The shareholder of such a fund faces the troublesome prospect of having invested in a poorly performing fund while still having to pay its share of the capital gains taxes on the fund.

Long-term investors really should not care much about the inability to trade mutual funds during any day. But, the tax issue is another concern and that could become important to you.

Because of the tax problems inherent in mutual fund investments and out of a demand to provide mutual funds with daily trading capability, a type of fund has been created called an “exchange-traded fund.” 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 hundreds of 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 is a mutual fund that mirrors an index. ETF’s look and act 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 Stock Exchange and the New York Stock Exchange. 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 indexes, ETFs are less expensive than managed mutual funds and today are priced even less expensive than index mutual funds. Mutual fund management is problematic. Mutual funds that perform very well in one year may be underperformers the following year—performance depends on so many factors dealing with the management of the fund. As an investor, you are paying fees for the management of the mutual fund. For the most part, however, mutual fund managers do not outperform benchmark indices. That means your payment of extra fees for the management of the mutual fund may be wasted. Is this true of all mutual funds? No, not all, but many.

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 and asset allocation is critical to your success as a long-term investor. ETFs have taken their place in portfolios as a cost-effective means of diversification. In short, ETFs make sense for anyone’s portfolio.

Lyn & TeddyAbout 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” (2013 ebook download available at LegalStriegel.com.). Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel.