What is an ETF: 101
That is a simple question, but the problem is when you ask investors who are 50+, the reality is they don’t know and haven’t received the basic communication they desperately need from advisors.
ETFs (Exchanged Traded Funds) are very similar to mutual funds. ETFs typically represent a basket of securities known as pooled investment vehicles and trade on a stock exchange like individual stocks. Most ETFs are registered investment companies that offer investors a share in a professionally managed portfolio of securities, like stocks or bonds. That is also the primary difference between mutual funds and ETFs, the ETF has shares that can be bought and sold at ANY time throughout the trading day while mutual fund shares can only be bought and sold at the END of each trading day.
Like a stock
-Trading flexibility intraday on the exchange
-Long or short
Like an index fund
-Constructed to track benchmark indexes
-Low expense ratios
BREAKING DOWN ‘Exchange-Traded Fund (ETF)’
An ETF is a type of fund that owns the underlying assets (shares of stock, bonds, oil futures, gold bars, foreign currency, etc.) and divides ownership of those assets into shares. The actual investment vehicle structure (such as a corporation or investment trust) will vary by country, and within one country there can be multiple structures that co-exist. Shareholders do not directly own or have any direct claim to the underlying investments in the fund; rather they indirectly own these assets.
ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and they may get a residual value in case the fund is liquidated. The ownership of the fund can easily be bought, sold or transferred in much the same was as shares of stock, since ETF shares are traded on public stock exchanges. *
The First ETF
Tom Lydon from ETFtrends.com explains….
It All Began With a Spider. The introduction of an ETF that tracks the S&P 500, the SPDRs (NYSEArca: SPY) kicked off the industry. By the end of 2009, there were nearly 1,000 exchange traded products trading on U.S. exchanges, and even more than that around the world. It took mutual funds decades to get to this point. **
What types of ETFs are there?
While there are more than 1,640 ETFs available today, more than 99% of the assets are invested in traditional index-based ETFs. Index-based ETFs are available in nearly every style and asset class, covering virtually every segment of the domestic and global equity and fixed income markets. They range from products that invest in the widest coverage of the markets, to those that invest in specific industries.
There are style ETFs that cover the growth and value spectrum and those that track certain market capitalizations. International ETFs cover the global markets and offer exposure to a single country or region of the world. And, finally, there are bond ETFs that cover a variety of duration, credit quality, and maturity ranges. ***
Actively managed ETFs
These types of ETFs are managed to meet a particular investment objective. The portfolio manager actively manages the assets within the ETF to achieve that objective. Actively managed ETFs represent only a small portion of the overall industry.
Commodity and currency ETFs
These ETFs invest in the commodities and currency markets through either physical assets or through the futures markets, allowing investors to gain exposure to alternative investments such as agricultural products, precious metals, energy, and currencies. These ETFs are primarily non-1940 Act–regulated investment vehicles.
These are ETFs that use financial derivatives and debt to improve upon the returns of an underlying index. Leveraged ETFs attempt to produce twice or even three times the daily return of their underlying benchmark. This means that losses will also be amplified by two or three times the benchmark return.
These ETFs use derivatives to profit from a decline in the value of an underlying asset or instrument. These ETFs are designed to move in the opposite direction from the market they are trying to mirror. Investing in inverse ETFs is popular for short-term traders looking to hedge longer investments or take advantage of falling markets.
Please note that leveraged and inverse ETFs typically are designed to track a multiple of, or the inverse of, a daily return of the index. These ETFs are not designed to sustain this same multiple or inverse of index return over longer time periods. ***
Of course, there are the typical examples of various index types as well.
What Should Someone Know Before Investing in ETFs?
Choosing the right investment for your portfolio is not as easy as they make it sound on TV. You need to especially watch out for so-called Guru’s with their fear mongering. Investors should always carefully consider the objectives, risks, and costs associated with an investment in an ETF. This type of information can be found in 2 areas. The summary prospectus and the long-form prospectus. Call, email or do your research online, but you may also wish to consult a fee-only wealth manager. Here are a couple areas you should familiarize yourself with.
What is the Investment Objective of the ETF?
An ETF originates with a sponsor, who chooses the investment objective of the ETF. In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index. Index-based ETFs track their target index in one of two ways. A replicate index-based ETF holds every security in the target index because it invests 100 percent of its assets proportionately in all the securities in the target index. A sample index-based ETF does not hold every security in the target index; instead the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for ETFs that track indexes containing securities that are too numerous (such as broad-based or total stock market indexes), that have restrictions on ownership or transferability (certain foreign securities), or that are difficult to obtain (some fixed-income securities).
The sponsor of an actively managed ETF also determines the investment objectives of the fund and may trade securities at its discretion, much like an actively managed mutual fund. For instance, the sponsor may try to achieve an investment objective such as outperforming a segment of the market or investing in a particular sector through a portfolio of stocks, bonds, or other assets. ****
Here are 3 Risks with ETFs:
Tax efficiency is one of the most promoted advantages of an ETF. While certain ETFs, such as a U.S. Stock Equity Index ETF, come with great tax efficiency, many other types do not. In fact, not understanding the tax implications of an ETF you’re invested in can add up to a nasty surprise in the form of a bigger-than-expected tax bill.
ETFs create tax efficiency by using in-kind exchanges with authorized participants (AP). Instead of the fund manager needing to sell stocks to cover redemptions like they do in a mutual fund, the manager of an ETF uses an exchange of an ETF unit for the actual stocks within the fund. This creates a scenario where the capital gains on the stocks are actually paid by the AP and not the fund. Thus, you will not receive capital gains distributions at the end of the year.
However, once you move away from index ETFs there are more taxation issues that can potentially happen. For example, actively managed ETFs may not do all of their selling via an in-kind exchange. They can actually incur capital gains which would then need to be distributed to the fund holders.
If the ETF is of the international variety it may not have the ability to do in-kind exchanges. Some countries do not allow for in-kind redemption, thus creating capital gain issues.
If the ETF uses derivatives to accomplish their objective, then there will be capital gains distributions. You cannot do in-kind exchanges for these types of instruments, so they must be bought and sold on the regular market. Funds that typically use derivatives are leveraged funds, and inverse funds.
Finally, commodity ETFs have very different tax implications depending on how the fund is structured. There are three types of fund structures and they include: grantor trusts, limited partnerships (LP) and exchange-traded notes (ETN). Each of these structures have different tax rules. For example, if you are in a grantor trust for a precious metal you are taxed as if it were a collectible.
The takeaway is that ETF investors need to pay attention to what the ETF is investing in, where those investments are located and how the actual fund is structured. If you have doubts on the tax implications check with your tax advisor.
One of the most advantageous aspects of investing in an ETF is the fact that you can buy it like a stock. However, this also creates many risks that can hurt your investment return.
First it can change your mindset from investor to active trader. Once you start trying to time the market or pick the next hot sector it is easy to get caught up in regular trading. Regular trading adds cost to your portfolio thus eliminating one of the benefits of ETFs, low fees.
Additionally, regular trading to try and time the market is really hard to do successfully. Even paid fund managers struggle to do this every year, with most not beating the indexes. While you may make money, you would be further ahead to stick with an index ETF and not trade it.Finally, adding on to those excess trading negatives you subject yourself to more liquidity risk. Not all ETFs have a large asset base or high trading volume. If you find yourself in a fund that has a large bid-ask spread and low volume you could run into problems with closing out your position. That pricing inefficiency could cost you even more money and even incur greater losses if you can’t get out of the fund in a timely fashion.
Increased Portfolio Risk
There are many types of risk that come with a portfolio, everything from market risk to political risk to business risk. With the wide availability of specialty ETFs, it’s easy to increase your risk across all areas and thus increase the overall riskiness of your portfolio.
Every time you add a single country fund you add political and liquidity risk. If you buy into a leveraged ETF you are amplifying how much you will lose if the investment goes down. You can also quickly mess up your asset allocation with each additional trade that you make, thus increasing your overall market risk.
By being able to trade in and out of ETFs with many niche offerings it can be easy to forget to take the time to ensure you are not too making your portfolio too risky. Finding this out would happen when the market is going down and there is not much you can do to fix it then. *****
Many investors don’t realize that may be paying too much in fees, as well as, the true risk their investments have. Remember 2008? If you are working with a broker who does not have a fiduciary duty, then maybe it’s time to get a second opinion.
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