Over the last few years exchange-traded funds (ETFs) have greatly increased in popularity. As of 2016, there was approximately $2.9 trillion held in ETFs globally. Because of their growing popularity with financial advisers and individual investors alike, understanding the nuances of ETFs is critical in order for advisers to be better equipped to meet the ever-changing needs of their customers.
ETFs are comprised of a portfolio securities designed to replicate a particular index. Common examples of indices that ETFs replicate are the Dow Jones Industrial Average, the Standard & Poor’s 500 index, the Wilshire 5000 Total Market Index, and Barclays Capital US Aggregate Bond Index. Like many stocks, bonds, and mutual funds, ETFs can also be tracked daily in many financial publications and online.
Due to the lack of trading in the portfolio there are very little capital gains distributions in which investors must pay taxes. Because of this low turnover, investors rarely need to worry about the tax implications of security fluctuations in the portfolio.
Index Mutual Fund or ETF?
Although there are some similarities between index mutual funds and ETFs, there are some subtle differences to be noted.
ETFs can be traded throughout the trading day just like individual stocks. Index mutual funds are purchased or redeemed at the end of the trading day.
ETFs can be purchased on margin and sold short. Index mutual funds do not allow this.
Generally, ETFs are inexpensive to own. Since most ETFs are passively managed (they track an underlying index) there is little management once the portfolio is established. Expense ratios are generally lower than mutual funds, although some index mutual funds will have similarly low expense ratios as well.
Because of the low turnover an “in kind” exchanges in the portfolio, ETFs are extremely tax efficient. This can be advantageous for non-qualified (non-401k, non-IRA) accounts. Index mutual funds to have some tax efficiency, however they may not be as efficient due to transaction costs, index composition changes (a company leaving/joining the index), and fund cash flows.
In qualified accounts, there is little difference in tax efficiency between ETFs and index mutual funds. In non-qualified accounts, ETFs provide more tax efficiency.
Since ETFs trade like stocks, they may have trading commissions when they are bought and sold. Generally, index mutual funds are no load. However, some custodians offer commission-free ETFs.
ETFs may trade at a discount to the portfolio’s net asset value (NAV) while index mutual funds will trade at NAV.
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