Most of us are familiar with mutual funds. They have been around for a very long time. The idea behind them is that people pool their investment dollars into one large fund and pay a manager to accumulate a well-diversified portfolio of investments. Mutual funds can give small investors the power of diversification that would otherwise take large amounts of money. Over the past few years, however, another pooled investment product has become more and morepopular: The Exchange Traded Fund.
Mutual funds, for all their benefits, have their flaws. Because of how they are structured, they only price once per day, meaning they trade once at market close. They’re also not extremely tax-sensitive. Purchases and sales inside a mutual fund can cause a tax liability for the fund holder, even if the holder doesn’t buy or sell any shares themselves. All trade gains are passed through to the owner. They also tend to be large, holding hundreds of different positions. Investors looking to focus their portfolios on one particular market segment can have a difficult time doing that by using mutual funds.
Enter the Exchange Traded Fund, or ETF. Exchange Traded Funds attempt to check some boxes that mutual funds cannot. They issue a set number of shares that get traded on an exchange just like individual stocks. That means their price fluctuates all day, enabling investors to buy or sell shares more-or-less instantly.
In their infancy, ETF’s were mostly passive vehicles, using computer models to track an index like the S&P 500. Those passive ETF’s have extraordinarily low fees, as the computer models can do all the trading to follow a simple index formula.
Over the years, though, sector funds and actively managed ETF’s have become extremely popular as well. These sector ETF’s can focus on energy, microchip makers, cloud computing, or an almost unlimited array of other places in the market. The active and sector funds are generally more expensive to own than their passive brethren, but give investors opportunities to buy into a specific part of the market without having to pick individual companies in that part.
The most important part of ETF’s to tax-sensitive investors is their favored tax status versus mutual funds. Sales and purchases of securities inside an ETF aren’t taxable to the investor, as they are treated as an exchange. While dividends are still taxed, the majority of the taxable gain in an ETF can be managed by the shareholder. That is to say that an owner of ETF shares can choose when to sell shares and trigger a taxable event.
Exchange Traded funds are a very useful tool for most investors. Between their dynamic portfolios and their favored tax status, they can be a powerful part of your portfolio.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All indices are unmanaged and may not be invested into directly.
ETF’s trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF’s net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETF’s carry additional risks such as not being diversified, possible trading halts, and index tracking errors.
ETF’s concentrating in specific industries are subject to higher risks and volatility than those that invest more broadly.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.