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What are Exchange Traded Funds?

What are Exchange Traded Funds or ETFs?  ETFs are baskets of individual assets. These baskets can be composed of stocks, bonds, or commodities. ETFs, like mutual funds, offer investors the opportunity to invest in other countries and asset types (for example: gold or real estate) that until recently was unavailable to most investors.  ETFs provide investors with the ability to own a portion of large swaths of the market with a single purchase.  For example a single ETF share in an S&P 500 tracking ETF owns a piece of the 500 largest companies in the US. To purchase these assets individually would be cost prohibitive for all but a very few investors.

 ETFs are similar to mutual funds in their structure. However, there are several significant differences between ETFs and mutual funds. Below is a comparison of ETFs and mutual funds.

Cost to own.  As a rule ETF expense ratios are significantly lower than those of most mutual funds.  ETF providers do not take on the accounting in-house, nor do they include 12b-1 fees related to marketing costs, as mutual funds do. As a result the average ETF costs about .44% vice the average mutual fund expense ratio of about 1.40%.This equates to $44 per $10,000 investment in an ETF vice $140 per $10,000 investment in a mutual fund.

Tradability.While traditional mutual funds can only be redeemed at the end of the day, ETFs trade throughout the day, similar to common stocks. Although ETFs are often used as part of a buy-and-hold investment strategy, meaning that immediacy of trades is not a major concern, there are certain occasions when time will be of the essence. Due to this tradability, an investor can implement stop-loss orders on their holdings, thereby protecting any gains they may have and minimizing their losses. In such situations, ETF investors will be able to execute a trade immediately, while mutual fund investors will be left waiting until the close of the markets to execute their trades.

Transparency or daily disclosure.  Unlike mutual funds, which are required to disclose their holdings only four times per year, ETFs are required to release holdings data on a daily basis. Although this may not seem like a significant advantage, it can be important in certain situations. For example, let’s assume that a major U.S. investment bank has just announced that it is no longer solvent and is expected to be wound down and sold for pennies on the dollar (sound familiar?). Mutual fund investors would have difficulty uncovering their level of exposure to the distressed company, since quarterly disclosure filings may be drastically out of date by that point. ETF investors, on the other hand, would have immediate access to any ETF’s holdings as of the close of trading on the previous day. 

Tax efficiency. When an investor buys shares in a mutual fund or an ETF within a taxable account and over time the value of the holding increases, there is a capital gain liability. In a mutual fund, if a single investor sells his or her shares in order to make a withdrawal, all the other mutual fund investors incur a capital gain tax liability.However, because ETFs are bought and sold the same way as stocks are, investors do not realize the capital gain until they sell their shares.  This advantage is non-existent in a tax-deferred account such as an IRA or 401k. Provided the withdrawal is not made until the funds are needed for retirement, withdrawals from these types of accounts are treated as regular income. 

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