What is an ETF?

In recent years, ETF’s have come to the forefront of the investing world.

Touted for their low fees and passive management, investors are flocking to them like never before.

But what exactly are ETF’s? And why do some believe them to be the investment of the future?

ETF stands for exchange-traded-fund

What this means is that an ETF can be purchased and sold on an exchange (such as the New York Stock Exchange), just as you would buy a stock or a bond.

This is in contrast to a mutual fund, which can only be purchased or sold at the end of the trading day, after the markets have closed.

As such, ETF’s have greater liquidity (the ease with which you can purchase or sell an asset) than a mutual fund, which in financial markets, is always an advantage.

Think about what would happen if the U.S. stock market crashed. In a mutual fund, you would not be able to liquidate your assets mid-day. In an ETF, you would.

Passive Management

The investments within an ETF are not chosen by any one person, or by any investment management team.

ETF’s track an index, or an exchange (hence the name).

So for example, there is a Spyder ETF (ticker symbol SPY) that tracks the S&P 500.

There are, ironically, 500 stocks that make up the S&P 500, which is an index of the 500 largest U.S. based companies.

The SPY ETF owns, at all times, those 500 stocks.

They do not sell one stock if they believe it will go down, or buy one company if they believe it will appreciate.

It’s those 500 stocks, and that’s it.

This is in contrast to active management, as in a mutual fund.

With active management, there is a team of people that sit around all day, researching companies, and picking and choosing which investments they believe are best.

Out of the S&P 500, they may pick 30 companies that they believe will do better than the S&P 500 as a whole.

While there is considerable debate over a manager’s ability to pick better investments, one thing is for sure: They don’t work for free.

ETF Fees

Because there is no one person, or team of people, picking and choosing which investments to hold in an ETF, it is much easier, and cheaper, to manage them.

“As such, the fees an ETF charges its investors are typically below those charged by actively managed funds”

There are, as always, exceptions. For ETF’s that track less liquid, or emerging market indexes, fees will tend to be higher than they might be in a domestic ETF.

However, relative to mutual funds, they will almost always be lower.

Taxes

ETF’s have certain tax planning advantages as well.

Thanks to certain IRS tax rules, when an exchange traded fund makes a trade (for example, if the S&P 500 removes one company from its index and adds another, the SPY must follow suit), there is no tax consequence to the investor.

In a mutual fund, on the other hand, when a trade is made, any capital gain on that trade gets passed on as a capital gain to the investor, regardless of whether or not you sold any shares of the fund.

Investing in ETF’s makes tax planning much more predictable, as you are more certain about when and if there will be any taxable gains or losses.

Exotic ETF’s

Exotic ETF’s, ETF’s that are not what one would consider your “index-tracking ETF,” have recently been coming onto the market.

Leveraged ETF’s and inverse ETF’s seem to be the most popular, attempting to provide twice the return of the index, in some cases.

In addition to carrying greater risks, these ETF’s have complicated pricing structures that make them inappropriate for long-term investors.

They were designed for, and are primarily used by, day-traders and others who fully understand the structure of the fund, and the risks inherent in it.

I would strongly suggest not using these funds on your own, unless you are going to do a significant amount of research, or work with a qualified professional to obtain advice.

Your thoughts?

Now that you have a better understanding of what ETF’s are and how they work, what are your thoughts?

Do you think they are an overall good investment strategy? Do you think they are better than mutual funds?

Increasingly, they are available as investment options in your 401(k), so if you haven’t come across them yet, chances are you will soon!