Have you ever heard of an “Exchange Traded Fund,” otherwise known as an “ETF?” If you’ve ever invested in mutual funds but never heard of an ETF, you owe it to yourself to learn a little about what I often call one of Wall Street’s greatest inventions ever.
Like a mutual fund, an exchange- traded fund (ETF) pools money from investors to buy a group of securities. Though diversification alone can’t guarantee a profit or protect against potential loss, such an investment helps you spread your risk over many individual securities.
Most ETFs are passively managed. Instead of having a portfolio manager who uses his or her judgment to select specific stocks, bonds, or other securities to buy and sell, ETFs try to approximate the performance of a specific index, which can be either broad-based or narrowly focused. In this, they are somewhat similar to an index mutual fund.
However, there are some substantial differences between mutual funds and ETFs. Perhaps the biggest is the ability to trade ETFs throughout the day. Mutual funds are priced once a day after the market closes. If you buy or sell after that, you’ll receive the next day’s closing price. By contrast, ETFs are priced throughout the day. Also, they can be bought on margin or sold short; in other words, they can be traded just like stocks. As a result, investors may use ETFs to actively trade a particular sector or industry.
ETFs typically have no minimum investment requirements or redemption fees for brief holding periods. And because most ETFs are based on an index, the administrative costs can be relatively low. However, ETFs must be purchased through a broker. Since you’ll pay a brokerage commission with every transaction, ETFs may not be well-suited to a systematic investing program such as dollar cost averaging–transaction costs could quickly eat up any cost efficiencies.
Because the differences between one ETF and another can be dramatic, you should carefully consider a fund’s investment objectives, risks, charges, and expenses, which are included in the prospectus available from the fund. Read it carefully before investing.
How can I use exchange-traded funds?
There are many ways an exchange-traded fund (ETF) can be used to help round out or supplement an existing investment portfolio.
Investing in a sector rather than an individual stock. An ETF allows you to invest in an industry or sector without relying on the fate of an individual company. If you have broadbased stock funds, you can give more weight to a particular sector by also investing in an ETF that focuses on a relevant index.
Minimizing taxes. ETFs can be relatively taxefficient. Because a passively managed ETF trades relatively infrequently, it typically distributes few capital gains during the year. That means you won’t incur the same tax liability as if you received significant capital gains. However, make sure you consider just how an ETF’s returns will be taxed. Depending on how the fund is organized and what it invests in, returns could be taxed as short-term capital gains, ordinary income, or even as collectibles, all of which are generally taxed at higher rates than long-term capital gains.
Staying invested after selling stock for a tax loss. If you have sold a large stock position to realize a capital loss for tax purposes, but still believe that industry as a whole will soon experience a big short-term move, you can use an ETF to try to take advantage of that volatility. If you buy the same stock within 30 days, the tax-loss deduction will be disallowed. However, buying an ETF based on a relevant index as a proxy for that investment until you are able to buy the stock again allows you to preserve the tax deduction on the stock loss while staying invested in that industry.
Limiting losses. With an ETF, you can set a stop-loss limit on your shares. A stop-loss order instructs your broker to sell your position if the shares fall to a certain price. If the ETF’s price falls, you’ve minimized your losses. If its price rises over time, you can increase the stop-loss figure accordingly. This strategy lets you pursue potential gains while setting a limit on the amount you can lose.
Be sure to carefully consider a fund’s investment objectives, risks, charges, and expenses, which are included in the prospectus available from the fund. Read it carefully before investing.
