Getting to know exchange-traded funds

A growing number of investors are using exchange-traded funds (ETFs) to build diversified portfolios. Maybe you should, too — if you understand the risk/reward trade-offs.
An ETF is a basket of securities, shares of which are sold on an exchange. They combine features and potential benefits similar to those of stocks, mutual funds, or bonds. Like individual stocks, ETF shares are traded throughout the day at prices that change based on supply and demand. Like mutual fund shares, ETF shares represent partial ownership of a portfolio that's assembled by professional managers.

Types of ETFs

There are a number of types of ETFs, each with a different investment focus. Following are some of the most common ETFs.
  • Diversified passive equity ETFs are designed to mirror the performance of widely followed stock market benchmarks such as the S&P 500, the Dow Jones Industrial Average, and the MSCI Europe Australasia Far East (EAFE) indexes.Footnote 1 Major index-based ETFs have tended to follow their performance benchmarks closely.
  • Niche passive equity ETFs such as those that mirror the sector subsets of the S&P 500 or the small companies of the Russell 2000, may offer investors focused exposure to help them fine-tune their portfolio strategies. As with diversified passive funds, these niche portfolio funds are generally made up of the same stocks as those used to calculate their reference indexes.
  • Active equity ETFs allow their managers to use their own judgment in selecting investments, rather than rigidly pegging to a benchmark index. Active ETFs may offer the potential to outperform a market benchmark but may also carry greater risk and higher costs.
  • Fixed-income ETFs focus on bonds rather than stocks. Major fixed-income ETFs tend to be actively managed, but have relatively low turnover and generally stable portfolios.

Different structures

Originally, ETFs were organized as unit investment trusts (UITs). In a UIT, an investment company buys a fixed portfolio of securities and then sells shares of that portfolio to investors. This type of structure results in dividends being held in an interest-bearing account, from which they are deposited into the ETF, generally once each quarter. The delay in investing dividends can have a slightly negative effect on the total return of the ETF because the dividends are held as cash instead of being invested.
Other ETFs are structured as open-end funds. This arrangement follows the typical mutual fund structure in that new shares are continually offered and redeemed by the investment company. An open-end structure allows dividends to be reinvested immediately.
ETFs
Advantages
  • Potential tax efficiency
  • Low expense ratios
  • Trades throughout the day on an exchange
  • No minimum investment dollar amount (may not buy fractional shares)
  • Can be sold short and bought on margin
Disadvantages
  • Brokerage commissions incurred
  • Capital gains occasionally distributed
  • Flexibility may encourage frequent trading, potentially negating the tax-efficient edge
  • Possibility of losing money

Evaluating ETFs

These investments offer a number of potential advantages, including:
Tax efficiency — ETFs may be more tax efficient than some traditional mutual funds. A mutual fund manager may trade stocks to satisfy investor redemptions or to pursue the fund's objectives. Selling shares may create taxable gains for the fund's shareholders. Because ETFs are like stocks, redemptions aren't an issue. In addition, managers of index-based ETFs only make trades to match changes in their index, which may mean greater tax efficiency.
Low expenses — ETFs that are passively managed (managers usually only trade shares to mirror underlying benchmarks) may have lower annual expenses than actively managed funds.
Flexible trading — Like stocks, ETFs are sold at real-time prices and trade throughout the day. Mutual funds, on the other hand, do not have this flexibility: Their pricing is based on end-of-day trading prices.
Can be sold short and bought on margin — Because ETFs trade like stocks, investors can use them in certain investment strategies, such as selling short and buying on margin.
No minimum investment — Most mutual funds require a minimum investment, whereas an investor can usually purchase as few shares of most ETFs as desired.
Diversification — An ETF may be a good way to add diversification to your portfolio. Buying shares of a technology sector ETF, for example, could potentially be less risky than purchasing shares of one technology stock — an ETF may own shares of many different technology companies.
Inquiring minds want to know...
There are a number of web resources that you can turn to for more information about ETFs.
  • ETF.com — News, data, and analysis on ETFs
  • ETF MarketPro — Education, prices, research, and other tools specifically for ETFs
Of course, as with all investments, ETFs may involve risks and other potential drawbacks. Consider these factors before investing:
The trading flexibility of ETFs may encourage frequent trading. That could lead to the possibility of mistiming the market (moving stocks in and out of the market at the wrong times).
Brokerage commissions are incurred. For this reason, ETFs may be better suited for a buy-and-hold investor or someone who is buying a large number of shares at one time, rather than for an investor who uses a systematic investment program.
There may be capital gain distributions. At times, some ETFs have distributed taxable capital gains usually because the managers have needed to buy or sell stocks to match their underlying benchmarks. Additionally, government bond ETFs are subject to federal income tax.
You should carefully consider the risks of different ETFs. Many sector ETFs, for instance, will tend to be more volatile than an ETF that tracks the broader market. Check with a financial professional to be sure that you understand the risks and have the most up-to-date information before investing in an ETF.

Footnote 1 Investors in international securities are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Sector funds are subject to increased volatility due to their limited diversification compared with other stock funds.

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