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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.
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