The Basics of ETFs

William Suplee |

Over the last decade, the use of Exchange Traded Funds (ETF’s) has grown at high rates as investors have found a complement to mutual fund investing. New developments in ETFs will allow for higher tax efficiency. The SEC has a rule that allows conversion of some Mutual Funds directly to ETFs without investors realizing any gains in the transfer - and benefiting from the tax advantages of ETFs in the process.

There are significant differences between mutual funds and ETFs and those differences are important to understand before using one versus the other. Exchange-traded funds are baskets of securities—stocks, bonds, commodities or a combination of the three. The fund provider owns a group of assets and creates a fund to track the group’s performance. They then sell shares of that fund to investors. Some well-known ETFs include SPDR S&P 500 (SPY), which tracks the S&P 500 Index, and SPDR Gold Shares (GLD), which tracks physically-backed gold securities.

One of the advantages of investing in an ETF is that like a mutual fund, you get diversification of funds without having to invest in each asset individually. The fund provider maintains the asset allocation just like the mutual fund company does with their funds. ETFs are similar to mutual funds, with a few key exceptions.

First, ETFs are traded on an exchange throughout the day, much like stocks. Mutual funds, on the other hand, are traded just once per day after the markets close. The price of an ETF could change throughout the day, but a mutual fund’s price will update once daily. When you invest in an ETF you need to be careful when trading as the price you pay might not be the value of the underlying securities while with a Mutual fund everyone(buyers and sellers) gets the same fair asset value price once a day.

There may also be lower cost and more tax-efficiency advantages to investing in an ETF versus a mutual fund. Investors in ETFs (with a few exceptions) are only taxed upon selling their investment, whereas mutual fund investors can incur a tax burden over the course of their investment. Both ETFs and mutual funds pay dividends but mutual funds can also have capital gains distributions that are not usually associated with ETFs.

The big news on the ETF front is that certain firms like Dimensional Fund Advisors have come up with a method to convert existing mutual funds to ETFs without a realized tax consequence. These will first be used for the most tax sensitive investors. Funds that have previously had capital gains distributions will now have none and the taxable investor is better off.

Although ETFs offer many benefits, there are some things to consider before investing. Commissions and transaction charges are usually low but should be checked. You need to be careful when trading ETFs. In fast markets like we experienced in March there can be wide diversions between ETF prices and the underlying values. If you have questions or want to discuss reach out to me.