Introduction
Exchange Traded funds (ETFs) have become an increasingly popular investment option over the last couple of decades. There is now over $4 trillion worth of assets that are invested in ETFs worldwide. The largest and oldest ETF, the SPDR S&P 500 (SPY) has nearly $237 billion in assets and is consistently one of the most highly traded securities in U.S. exchanges. In spite of this, I’ve found that many investors are still kind of confused on what exactly an ETF is. Many times, they’ve heard about them, but are still kind of fuzzy on the details of how they work.
So what exactly is an ETF? Over the course of this blog I’ll dive in to the chief characteristics of ETFs and try to explain the similarities and differences compared to other investment vehicles, such as mutual funds.
Characteristics of ETFs
ETFs provide Diversification for Investors
Similar to a mutual fund, an ETF is an investment vehicle that is comprised of a basket of underlying securities (stocks, bonds, REITs, commodities, etc.) that are bought and sold by the fund. By purchasing an ETF, the investor is able to obtain broad diversification (thousands of companies in many cases) across an entire market, a particular sector of the market, a particular asset class, country, or investment style. Generally, diversification is a good thing, as it reduces the inherent risk that you have in your investment portfolio. For the average investor, it would be prohibitively expensive to purchase each of the underlying securities themselves, but ETFs allows the investor to achieve broad diversification at an affordable price.
ETFs are Traded on an Exchange
As the name implies, Exchange Traded Funds are traded on exchanges, such as the New York Stock Exchange or the NASDAQ. This is one of the key differences between an ETF and a mutual fund.
If you’ve ever purchased or sold shares of individual stock before, the process of purchasing or selling shares of an ETF is identical. Shares of ETFs are traded intraday with prices being updated in real-time. Because of this, when you purchase a share of an ETF, you know immediately what you paid to acquire that share. If you purchase a share of an ETF for $100 at 10 am, for example, then it doesn’t matter what happens the rest of the day, because you purchased that share for $100.
Mutual fund shares, on the other hand, are not traded on an exchange, but are rather purchased and redeemed directly from the mutual fund company (albeit sometimes through an intermediary, like a broker-dealer). The price that you buy or sell at is not known until the end of the day when the mutual fund determines what the Net Asset Value (NAV) is of the fund. This can lead to significant differences in purchase prices for similar assets purchased at the same time on the same day for ETF and mutual fund investors on days with high volatility.
To illustrate this point, let’s use a similar example to the one above. Let’s say that you decided to buy shares of an S&P 500 mutual fund at the beginning of trading one morning and so you went ahead and submitted a buy order. It happened to be a very good day in the market and between the time you submitted the buy order and the close of the market for the day, the S&P 500 gained 5%. Even though you purchased the mutual fund shares early in the day, you will be buying the shares at NAV at the end of the day, so basically at a 5% premium of what the market was trading at when you decided to purchase the fund. Had you made the purchase in an S&P 500 ETF fund that morning, however, you’d have a gain of 5% by the end of the day.
Obviously, the price could have gone down by 5% just as easily as it went up by 5% and you could have ended up purchasing the shares at a 5% discount by using a mutual fund instead of an ETF. The point of the illustration is to just show the difference between how an ETF and a mutual fund is acquired. The ETF is purchased at a spot price intraday on an exchange, while the mutual fund is purchased at NAV at the end of the day directly from the mutual fund company.
ETFs are Professionally Managed
Similar to a mutual fund, an ETF’s day-to-day operations and investment decisions are made by investment professionals. Most fund managers are Chartered Financial Analysts (CFAs) and have a team of analysts, economists, and traders that help to provide fund oversight and input in portfolio construction.
ETFs are Tax-Efficient
As a general rule, ETFs tend to be highly tax-efficient. There are two main reasons for this.
First, while there are some actively managed ETFs, the vast majority of ETFs are passively managed index funds. According to Morningstar, 84% of ETF assets were invested in funds underpinned by market-cap-weighted indexes as of 2019. Because of this, most ETFs have very low turnover in the portfolio, which in turn leads to less capital gain distributions being passed on to investors.
The second (and primary) reason for why ETFs are so tax efficient is because of how trades are made when changes are needed in the fund’s portfolio. This can be seen most clearly when comparing how trades within an ETF are made versus how trades within a mutual fund are made.
When a mutual fund manager needs to sell a security, whether it be to raise cash to cover fund redemptions or just to reinvest in another holding, the manager sells that position on the open market in exchange for cash. If the mutual fund sells the position for a profit, then the transaction will result in capital gains distributions that will be passed on to shareholders.
ETFs, on the other hand, are structured in such a way that allows fund managers to trade securities not only on the open market for cash but also allows them to trade in-kind with a financial intermediary known as an Authorized Participant (AP) for other securities. By trading in kind, the ETF is able to avoid realizing any capital gains from the transaction. Instead, the capital gains are embedded in the cost of the ETF and will be realized should the investor sell the ETF at some point in the future for a profit. Note that it is possible that an ETF may not be able to find an in-kind trade for every transaction and may need to sell some holdings on the open market. Thus, you may still have some capital gains distributions, but they are generally not as frequent and are for lesser amounts than mutual fund distributions.
One important point to stress is that ETFs will not insulate you from capital gains taxes to the extent where you will never have to pay them. Eventually when you sell your shares of the ETF, you will still have to pay capital gains taxes if your shares have appreciated in value. Thus, the ETF’s value is not to eliminate capital gains taxes entirely, but rather to reduce the capital gains tax drag experienced over the course of your holding period and giving you more control of the timing of taking capital gains distributions.
An ETF Generally Puts More of Your Money to Work than a Mutual Fund
Because ETFs are traded on an exchange and do not directly redeem shares whenever investors decide to sell, they generally do not have to carry as much cash on hand as mutual funds do. Thus, more of your money is able to be put to work in the underlying investments instead of sitting in cash.
ETFs Trade in Full Shares
One important thing to note is that unlike mutual funds, which can trade in partial shares, ETFs are traded in whole shares. There’s a positive and a negative to this.
The positive side is that many ETF shares trade for a couple of hundred bucks or less, which is generally less than the minimum contribution amount required to open up a mutual fund account (Vanguard’s minimum averages around $3,000 in initial contribution). Thus, ETFs might provide a good way of getting your feet wet in investing if you have little to contribute initially.
The negative side is that if you are wanting to dollar cost average a fixed amount of money into an investment account each month, it will be difficult to purchase the same amount each month, as the share price will vary from month to month. In those cases, it is probably best to use mutual funds, as they will allow you to purchase partial shares of their funds, which makes dollar cost averaging much easier to do.
Conclusion
ETFs can be a solid, low-cost option for investors that are looking to get broad diversification inside one investment vehicle. For those that have large portfolios in taxable accounts or for times of high volatility, ETFs could possibly be a good alternative to mutual funds. If you have additional questions about ETFs or want to know if ETFs could be a good solution for your individual financial situation, feel free to sign up for a free initial consultation with me.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
