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What Are Exchange-traded Funds and How Do
They Work?
An exchange-traded fund (ETF) is a basket of securities
created to track as closely as possible a particular market
index, such as the Standard & Poor's 500 Index or the Dow
Jones Industrial Average. They're similar to mutual funds in
that they represent investments in the same types of securities,
but they generally have lower fees and can be bought and sold
with more pricing immediacy than mutual funds. They also have
some clear tax advantages.
Since their launch in the early 1990s on the American Stock
Exchange, there are now hundreds of ETFs available for investors
to buy. As the market has struggled its way back since 2000,
investors have embraced ETFs as a more efficient alternative to
a mutual fund invested in the same securities. A financial
planner can tell you whether ETFs are right for your portfolio,
but here are some details to know beforehand:
How are ETFs created? An ETF is created by large
institutional investors who buy stocks aligning with the shares
in a particular index, and then they exchange those shares — in
baskets as large as 50,000 shares — for shares in the ETF. The
redemption process works the same way in reverse — the
institutional investors exchange shares of the ETF for baskets
of the underlying stocks.
Are all ETFs based on indexes? Yes. Indexes, like the
S&P 500 or the Hang Seng Index (the primary stock index of
the Hong Kong Stock Exchange), are a listing of stocks
reflecting the activity of a particular investment sector on a
stock exchange. One of the first popular ETFs had an unusual
nickname — Spiders — a play on its actual name, SPDR, short for
Standard and Poor's Depositary Receipts. Newer ETFs track less
well-known indexes, even indexes of bonds, and some ETFs are
tracking very dynamic indexes that almost act like actively
managed funds.
How are ETFs traded? Unlike mutual funds, which have
their prices set at the end of the trading day, ETFs are priced
and traded every moment of the trading day. That's generally
more meaningful to institutional investors who buy and sell
constantly than long-term investors who buy and hold.
Furthermore, unlike mutual funds, ETFs can be bought on margin
or sold short.
Why might ETFs be more tax-efficient? Generally, ETFs
generate fewer capital gains due to the unique creation and
redemption process as well as the usually lower turnover of
securities that comprise their underlying portfolios. Financial
planners note that investors can better control the timing of
the tax treatment of ETFs relative to mutual funds. Most
importantly — by holding an ETF for at least one year and a
day, capital gains will be treated as long-term capital gains,
which are currently taxed at a federal rate of 15 percent (5
percent for low tax bracket investors).
Are there other advantages? Unlike traditional mutual
funds, which must disclose their holdings quarterly, ETF
holdings are fully transparent, and investors know what holdings
are in the ETF at any given time. Each ETF also has a NAV
tracking symbol for even more precise analysis. This helps keep
ETFs trading within pennies of their intraday NAV.
What about fees? Shares of index-based ETFs may have
even lower annual expenses than similar index mutual funds,
which, in turn, tend to be lower than those of actively managed
mutual funds. ETFs must, however, be bought and sold through
brokers, and those trades do involve transaction costs. ETFs may
prove to be more expensive than mutual funds to investors who
add money each month to their portfolio.
What's the downside? Unlike regular mutual funds, ETFs
do not necessarily trade at the net asset values of their
underlying holdings. Instead, the market price of an ETF is
determined by supply and demand for the ETF shares alone.
Usually, the ETF value closely mirrors the value of the
underlying shares, but there's always a chance for ETFs to trade
at prices above or below the value of their underlying
portfolios. Also, since so many new ETFs are hitting the market,
investors should be aware of the maturity of the particular ETF
they are considering.
April 2007 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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