“An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold.” (Source: Investopedia)
ETFs are similar to index funds, like index mutual funds, but they trade like stocks. It is good to know that you can get in or out of the ETF during the day instead of at the end of each day as with mutual funds. Many good ETFs have very low fees, compared with traditional mutual funds, and they could cost you less in taxes since their structure is often more tax-efficient than traditional mutual funds.
ETFs provide a way to invest in specific sectors of the stock market (for example, small-cap, energy, consumer staples, and financials) or you can track the entire market (S&P 500, Russell 3000). There are more than 1,700 ETFs on the market, however not all of them are created equal.
There are different structures to ETFs and they are generally pretty efficient because of the way they are built. However, some unique aspects of the structure should be considered when investing in a particular ETF. The most common legal structure is an Open-Ended EFT which has the fewest limitations. Another structure, for example, is an ETF set up as a Limited Partnership such as some agriculture or gold funds, where capital gains are taxed at a hybrid rate of 60% for long term gains and 40% for short-term gains and investors receive a K-1 tax form. (Source: IRS tax code)
Other structures include Grantor Trust where capital gains are taxed as if you owned the underlying assets where you could pay a “collectibles” tax up to 40% on short term gains, or UITs (Unit Investment Trust) that are limited on what they can hold and do not reinvest in dividends and are prohibited from holding securities outside the index it tracks. This makes that structure less flexible and more difficult to manage.
The ETF fund is created a little differently than the usual mutual fund and is more complicated than this newsletter article. A simplified explanation is that to create an ETF, an authorized participant (market makers or large institutional such as Blackrock, Vanguard) assembles a portfolio of stocks and turns them over to the fund in exchange for shares in the fund. Those shares issued are the ones traded on the exchanges and the way we typically buy ETF shares.
Not only are ETFs efficient, and in most cases cost effective, we like to use them to keep portfolios diversified. There is a lot more to understand about the creation and redemption of ETFs then we can cover here. Choosing an ETF involves more than simply choosing the lowest expense ratio or the broadest index. If you have any additional questions, please feel free to contact us.