The pros and cons of Exchange-Traded Funds
4 stars based on
Exchange-traded funds ETFs have become increasingly popular since they were introduced in the United States in the mids. Their tax efficiencies and relatively low investing costs have attracted investors who like the idea of combining the diversification of mutual funds with the trading flexibility of stocks. ETFs can fill a unique role in your portfolio, but you need to understand just how they work and the differences among the dizzying variety of ETFs now available.
Like a mutual fund, an exchange-traded fund pools the money of many investors and purchases a group of securities. Like index mutual funds, most ETFs are passively managed. Instead of having a portfolio manager who uses his or her judgment to select specific stocks, bonds, or other securities to buy and sell, both index mutual funds and exchange-traded electronically traded funds pros and cons attempt to replicate electronically traded funds pros and cons performance of a specific index.
Since their inception, most ETFs have invested in stocks or bonds, buying the shares represented in a particular index. Other ETFs invest in hard assets—for example, gold. More and more new indexes are being introduced, many of which cover narrow niches of the market, or use novel rules to choose securities.
Many so-called rules-based ETFs are beginning electronically traded funds pros and cons take on aspects of actively electronically traded funds pros and cons funds—for example, by limiting the electronically traded funds pros and cons of the fund that can be devoted to a single security or industry. ETFs can be bought on margin, sold short, or traded using stop orders and limit orders, just as stocks can.
ETFs do not have to hold cash or buy and sell securities to meet redemption demands by fund investors. Annual expenses are often lower, which can be especially important for long-term investors electronically traded funds pros and cons ETFs typically trade securities infrequently, they have lower annual taxable distributions than a mutual fund. Making frequent investments over time will require paying repeated commissions and will increase investing costs.
If an ETF is organized as a unit investment trust, delays in reinvesting its dividends may hamper returns. New and unique indexes are being developed every day. As a result, ETFs that might seem similar—for example, two funds that invest in large-cap stocks—can actually be quite different.
Many indexes define which securities are included based on their market capitalization—the number of shares outstanding times the price per share.
Why is weighting important? For example, an index that is weighted by market cap will be more affected by underperformance at a large-cap company than it would be by an underperforming company with a smaller market cap. As indicated above, one of the reasons ETFs have gained ground with investors is because of their low annual expenses. Also, investing in an index means that trades are generally made only when the electronically traded funds pros and cons itself changes.
As a result, the trading costs required by frequent buying and selling of securities in the fund are minimized. Note, though, that individuals cannot invest directly in any index. That means a one-time lump-sum investment in an ETF will be more cost-effective than frequent, regular investments over time.
ETFs can be relatively tax efficient. Because it trades so infrequently, an ETF typically distributes few capital gains during the year. There can be times when some investors find themselves paying taxes on capital gains generated by a mutual fund, even though the value of their fund may actually have dropped. Just how much impact can reducing taxes have over the long term?
More than you might think. This hypothetical example is for illustrative purposes only and does not represent the performance of any particular investment. Actual results will vary. Depending on how the fund is organized and what it invests in, returns could be taxed as short-term capital gains, ordinary income, or in the case of gold and silver ETFs, as collectibles; all are taxed at higher rates than long-term capital gains.
Broadridge Investor Communication Solutions, Inc. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials.
The information in these materials may change at any time and without notice. Securities and investment advice offered through Investment Planners, Inc. Eldorado Street, Decatur, IL What is an ETF? Electronically traded funds pros and cons ETFs invest Since their inception, most ETFs have invested in stocks or bonds, buying the shares represented in a particular index.
The cost advantages and tradeoffs of ETFs As indicated above, one of the reasons ETFs have gained ground with investors is because of their low annual expenses. What are some other reasons investors use ETFs? To get exposure to a particular industry or sector of the market. Because the minimum investment in an ETF is the cost of a electronically traded funds pros and cons share, ETFs can be a low-cost way to make a diversified investment in alternative investments, a particular investing style, or geographic region.
Being able to set a stop-loss limit on your ETF shares can help you manage potential losses. A stop-loss order instructs your broker to sell your position if the shares fall to a certain price. If its price rises over time, you could increase the stop-loss figure accordingly. That lets you pursue potential gains while setting a limit on the amount you can lose. How to evaluate an ETF Look at the index it tracks. Understand what the index consists of and what rules it follows in selecting and weighting the securities in it.
Be aware that the performance of an unmanaged index is not indicative of the performance of any specific security. Individuals cannot invest directly in any index. The more straightforward its investing strategy, the lower expenses are likely to be.