Exchange Traded Funds (ETFs)-- Not for Everyone

Exchange Traded Funds (ETFs) are relatively new investments. For all practical purposes, ETFs act like open-ended, no-load mutual funds; however, they are not actually mutual funds. Instead, ETFs represent a cross between an exchange-listed stock and a mutual fund.

Like traditional mutual funds, ETFs allow investors to purchase a portfolio of stocks through a single investment that trades through the day like an individual stock. Because of their unique structure, ETFs offer the potential for greater tax efficiency, lower annual expenses, and increased flexible trading characteristics.

Tax Efficiency

Investors in taxable mutual fund accounts are becoming more knowledgeable about the impact of income taxes on mutual fund performance. Mutual funds do not pay tax themselves; the tax code requires that funds distribute dividends and capital gains equally on all shares without regard to individual investor holding periods. The bulk of mutual fund distributions are a result of funds selling previous year's winners, generating capital gains to its current shareholders. See our article on Mutual Fund Taxation.

Mutual funds have been successful in pulling in mountains of investors’ funds as a result of the ten-year bull market in equities. If a market correction causes massive shifts in these funds, a significant tax event would affect taxable investors, on top of their market losses.

ETFs are advertised to be more taxpayer-friendly than traditional mutual funds. ETFs, like index mutual funds, aim to match the performance of a stock market index. A key difference is that ETFs don't issue or redeem new fund shares to meet the buying and selling demand of individual investors. Because ETFs trade on an exchange, most shareholder activity is the matching of buyers and sellers of the ETF as opposed to trading activity in the underlying portfolio of equities. This design ensures that an ETF portfolio manager would not have to sell shares to meet a wave of redemption requests and, as a result, trigger large capital gains distributions for the remaining investors. This is no small advantage when you stop to think that many mutual funds have potential capital gains exposure of 20% to 30% of their total assets after ten years of almost endless market gains.

Costs

ETFs often are described in terms of their expense ratio advantage over traditional index mutual funds. Expense ratios have become increasingly important to investors because of the impact of expenses on fund performance. Generally, ETFs that track broadly diversified indexes have the lowest expenses, in the 0.18-0.25 percent range. ETFs tracking domestic sector indexes have somewhat higher rates, in the 0.25-0.60 percent range. These costs compare favorably with low cost index mutual funds and in many cases are lower.

Expense ratios do not tell the whole story of ETF costs. Buying and selling ETFs generate commissions, just as there would be for stock transactions. This eliminates some of the cost advantage for smaller investors who frequently invest a small dollar amount over time. Combining trading cost and annual operating expense results in cost advantages for diversified index funds in most cases, except for large dollar amounts or longer holding periods. This seems to eliminate most of the cost advantage for small investors using dollar cost averaging or monthly purchases to accumulate ETF shares.

Flexible Trading Characteristics

Mutual funds only trade at the end-of-day price. Buyers and sellers do not know the share price of the trade until day's end. This can be important to investors trying to time the market and take advantage of inter-day volatility. For long- term investors, this is less important.

In addition to inter-day pricing, ETFs can be sold short, as well as using put-and-call options to use as hedging vehicles. The important characteristic is that an ETF, while made up of many individual stocks, trades like one exchange-listed stock and has most of the trading characteristics of a stock, not a mutual fund.

Summary

Exchange Traded Funds (ETFs) are not for everyone. They can have important cost advantages over traditional index mutual funds for investors who have more than $50,000 to invest with an anticipated holding period greater than 3 to 5 years. Probably the biggest advantage of ETFs is for taxable investors who are concerned with potentially large mutual fund distributions and the impact of resulting taxes on investment performance. There is little or no ETF advantage for the tax deferred, long-term retirement investor.