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What are ETFs?

What are ETFs?

An ETF or an exchange traded fund is a collection of securities that trades on an exchange. Even though there are some similarities between ETFs and mutual funds, ETFs are a whole different category. ETFs were first introduced in the United States in 1993 and since then the assets under different ETFs have gone up to more than a trillion dollars. Once you understand what ETFs are, these can prove a good addition to your own portfolio. Before investing in an ETF, one must read the summary prospectus and the full prospectus.

Affordability

Similar to mutual funds, ETFs offer investors a share of ownership in pooled investments. Traditionally, ETFs have been indexed funds but since 2008, the SEC allows ETFs to be actively managed as well. So let’s discuss affordability in terms of an indexed ETF.

Say you wanted to own a slice of the entire market. You would need to own at least one share of each company in the market since you cannot own fractional shares. Amazon alone, in July 2019, would cost you about $2,000. To replicate the S&P 500 index you would need to buy shares of each company in the same proportion as in the index and would require at least a couple million dollars in July 2019. This would make ownership and diversification unaffordable for regular investors. ETFs may buy and hold a bucket of all securities in the same proportion as in an index in a depository (more on depositories later). It then creates large blocks of shares (often in multiples of 50,000). These shares are sold to investors who can trade them on the exchange just like regular shares. The price of an ETF share is more affordable compared to owning actual shares in the index. For example, the SPY ETF trades at about $300. If there is more demand for an ETF, the fund has the flexibility of creating more blocks of shares.

Trading flexibility

ETFs trade throughout the day unlike open-end mutual funds that only trade at the end of the day. This gives you some flexibility as far as trading is concerned.

Transparency

ETFs are required to publish fund holdings on a daily basis. Mutual funds, on the other hand, publish holdings less often like quarterly. This increased transparency helps you understand whether the actual holdings in the fund are in line with the mandates listed in the prospectus.

NAV

ETFs trade very close to their net asset value. There are no significant premiums or discounts. The reason being arbitrage. If the fund is trading at a discount to the NAV, arbitragers can step in and buy the ETF and sell holdings in the ETF. Increased demand for the ETF brings the price up eliminating the discount. Similarly, if the fund is trading at a premium, arbitragers can step in and buy the individual assets and sell the ETF. Increased selling eliminates the premium bringing the ETF price back in line with the NAV.

Cost savings

ETFs don’t have any load fees. This helps keep expense ratios lower than those for mutual funds. However, you must consider the expense ratio before evaluating comparable funds. Expenses can eat into your returns.

Taxes

If you own a mutual fund in a taxable account, you pay taxes on capital gains incurred by the mutual fund. Say, for example, your mutual fund purchases a security and sells it at a capital gain within a year, this gain will incur a short-term capital gains tax. The short-term capital gains tax rate is higher than the long-term capital gains tax rate in the United States. A mutual fund passes these gains to its investors. So even if the mutual fund itself has lost value since you bought it, you still have to pay a cap gains tax. In case of an ETF, you can decide whether you want to sell the ETF within a year of purchase and incur a short-term capital gains tax or hold it for over a year and incur a long-term capital gains tax. The tax code also allows you to reduce the overall tax by offsetting losses from losing positions against gains from winning positions.

Diversification

ETFs are a great way to achieve diversification at a lower cost. There are many sector ETFs if you desire to gain exposure to a particular sector. There are several ETFs that can help you gain exposure to international markets.

Risks

Investing in ETFs is not without risks. Although you can trade ETFs just like stocks, you still incur trading commissions. Look at brokerage accounts to learn about commissions. While ETFs trade very close to their net asset value, the bid/ask spread may be high, especially for less liquid ETFs. Also, sometimes arbitrage can fail and the ETF shares may trade at a high premium or discount occasionally. Leveraged ETFs have a higher risk of loss in down markets.

Trading strategy

ETFs are a great tax-efficient investment for your taxable portfolio. These are your portfolios other than your 401k, 529 college savings plans, Roth IRAs, etc. A simple strategy would be to buy and hold ETFs in your regular brokerage accounts. A good plan would be to transfer a certain percentage of your paycheck each pay period into your brokerage account and use it to buy a broad-market indexed ETF. This is if you believe that markets are efficient and you don’t have time to research individual stocks. Do pay attention to the expense ratios. You can also diversify and make tactical sector and country allocations to different sectors and countries. As a beginner investor, you should avoid leveraged ETFs. Consistency is the key to increasing your wealth over the long term. If you have a long investment horizon, even if the markets rise and fall, overall you will do just fine. It’s about your time in the market rather than timing the market.

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