ETFs are exchange-traded funds that take the advantage of mutual fund investing to the next level. ETFs can provide reduced operational expenses than traditional open-end funds and more flexibility, transparency, and tax efficiency in taxable accounts.
However, there are also disadvantages, such as trade expenses and the product’s learning complexity.
Most knowledgeable financial experts think that the benefits of ETFs outweigh the drawbacks by a wide margin.
ETFs offer several advantages over traditional open-end funds. The four most significant benefits are trading freedom, portfolio diversification and risk management, fewer costs, and tax savings.
Traditional open-end mutual fund shares are only traded once each day after the markets have closed. The mutual fund business that issues the shares is the only place to trade.
Investors must wait until the end of the day, when the fund’s net asset value (NAV) is disclosed, to find out how much they paid for new shares that day and how much they will receive for shares that day.
Most long-term investors can get by with once-a-day trading, but other people need more freedom.
During the day, when the markets are open, ETFs are purchased and sold. During normal exchange hours, the pricing of ETF shares is continuous.
Share prices fluctuate throughout the day, owing primarily to the fluctuating intraday value of the fund’s underlying assets. ETF investors know how much they spent on shares and how much they received after selling them in a matter of seconds.
The practically instantaneous trading of ETF shares makes intraday portfolio management a breeze. It is simple to transfer money between asset classes such as stocks, bonds, and commodities. Investors can quickly acquire their allocation into the investments they want in an hour and then adjust their allocation in the next hour.
That is not normally encouraging, but it is possible.
Changing classic open-end mutual funds is more difficult and can take several days. To begin, open-end share trades are normally accepted until 2:00 p.m. Eastern standard time.
That is to say, you have no idea what the NAV price will be at the end of the day. It is hard to predict how much you will earn when selling shares of one open-end fund or how much you should purchase from another.
ETFs’ trade order flexibility also allows investors to make timely investment decisions and place orders in a variety of ways.
Investing in ETF shares includes all of the trading combinations available when investing in common stocks, such as limit orders and stop-limit orders. ETFs can also be acquired on margin, which involves borrowing funds from a broker.
Every brokerage firm includes lessons on trade order types and margin borrowing requirements.
ETF investors can also engage in short selling. Shorting involves borrowing securities from your brokerage business and selling them on the market at the same time.
The aim is that the price of the borrowed securities will fall and you will be able to repurchase them at a lower price at a later date.
Risk management and portfolio diversification
Investors who lack expertise in specific sectors, styles, industries, or countries may rapidly seek to get portfolio exposure to those areas.
Given the large range of sector, style, industry, and nation classifications available, ETF shares may be able to provide an investor with convenient access to a certain market area.
ETFs are currently traded on almost every major asset class, commodity, and currency exchange throughout the world. Furthermore, unique new ETF forms represent a certain investing or trading approach.
For example, with ETFs, an investor can purchase or sell stock market volatility or invest in the world’s greatest yielding currencies on a continual basis.
In some cases, an investor may have high risk in a specific area but is unable to diversify that risk due to regulations or taxes.
In that instance, the individual can either short an industrial-sector ETF or buy an ETF that shorts an industry on their behalf.
For example, a semiconductor investor may have a high number of restricted shares.
In that case, the individual may wish to sell short shares of the Standard & Poor’s (S&P) SPDR Semiconductor ( XSD). This reduces one’s overall risk exposure to a downturn in that industry.
XSD is a market capitalization-weighted index of semiconductor firms listed on the New York Stock Exchange, the American Stock Exchange, the NASDAQ National Market, and the NASDAQ Small Cap exchanges.
All managed funds, regardless of structure, have operating expenditures. Portfolio management fees, custody costs, administrative expenses, marketing expenses, and distribution are examples of these costs.
Costs have historically played a significant role in projecting returns. In general, the lower the cost of investing in a fund, the higher the fund’s predicted to return.
When compared to open-end mutual funds, ETF operating costs can be reduced.
Client service-related expenses are passed on to brokerage firms that hold exchange-traded stocks in customer accounts, resulting in lower costs.
When a company does not have to maintain a contact center to answer queries from hundreds of individual clients, fund administration costs for ETFs can be reduced.
ETFs also have cheaper costs for monthly statements, notifications, and transfers. Traditional open-end fund companies are obligated to send shareholder statements and reports on a regular basis.
This is not the case with ETFs.
It is the responsibility of fund sponsors to provide that information solely to approved participants who are the direct owners of creation units. Individual investors buy and sell individual shares of similar stocks through brokerage firms, and the brokerage business, not the ETF providers, is responsible for serving those investors.
Monthly statements, annual tax reports, quarterly reports, and 1099s are all issued by brokerage firms.
Because ETF providers have a smaller administrative burden of service and record keeping for thousands of individual clients, they have lower overhead, and at least some of that savings is passed on to individual investors in the form of lower fund charges.
The absence of mutual fund redemption fees is another cost savings for ETF shares.
ETF shareholders avoid the short-term redemption costs paid by some open-end funds. For example, the Vanguard REIT Index Fund Investor Shares ( VGSIX ) carries a 1% redemption charge if held for less than a year. The Vanguard REIT ETF ( VNQ ) has the same portfolio but no redemption charge.
When compared to mutual funds, ETFs have two significant tax advantages.
Mutual funds often pay more capital gains taxes than ETFs due to structural differences. Furthermore, capital gains tax on an ETF is only payable when the ETF is sold by the investor, whereas mutual funds pass on capital gains taxes to investors during the life of the investment.
In brief, ETFs have reduced capital gains, which are only payable when the ETF is sold.
The tax situation for dividends is less favorable for ETFs.
ETFs, payout two types of dividends: qualified and unqualified.
For a dividend to be qualified, an investor must have held the ETF for at least 60 days before the dividend delivery date.
The tax rate on qualifying dividends ranges from 5% to 15%, depending on the investor’s marginal tax rate. Unqualified dividends are taxed at the same rate as the investor’s taxable income.
Exchange-traded notes are structured to avoid dividend taxation and are considered a subset of exchange-traded funds.
ETNs do not pay dividends; instead, the value of dividends is represented in the ETN’s price.