The use of Exchange Traded Funds (ETFs) by advisors and individual investors has continued to see steady growth, especially due to investors switching from mutual funds. This growth is likely due to their relative ease of use, lower costs (internal costs known as expense ratios), potentially greater tax efficiency and transparency of holdings.
ETFs trade during normal market hours (like stocks) which is different from mutual funds, who’s daily value are calculated based on the closing prices of the underlying holdings at the end of the trading day. This ability to trade an ETF during market hours allows investors to move in or out of their ETF positions more efficiently and for a known price.
ETFs also are subject to internal costs caused by turnover, rebalancing, and management of the ETF. When compared to the internal costs associated with mutual funds, ETFs typically are much less expensive to own in the long run.
Potential for Greater Tax Efficiency
Mutual fund managers are actively trying to beat a corresponding index. In order to do so, they are constantly looking for better performing investments, which can mean more trading inside the mutual fund, which can mean greater potential for capital gains – which are passed along to the investors in the fund. ETFs, typically closely follow indexes, which means much less trading to rebalance to the index.
Additionally, sometimes a large number of investors in a mutual fund seek to liquidate their shares which can cause the fund manager to sell holdings to raise cash. This creates additional potential for capital gains taxes. Because ETFs trade on exchanges, investors looking to raise cash simply sell their shares to other investors. This exchange-trading feature eliminates the need for the fund to liquidate holdings to raise cash. Of course, each individual investors that sells his/her shares are subject to capital gains or losses.
Transparency of Holdings
Mutual fund managers invest with a specific ‘theme’. This ‘theme’ is described in each fund’s prospectus. Outside of the stated theme however, it is nearly impossible to know on any given day, what the fund is invested in. Mutual fund companies are required to publish their holdings each quarter, but in between these publication dates, they can be actively buying or selling their holdings.
ETFs on the other hand, follow specific indexes, countries, sectors, industries, etc. In doing so, investors know exactly what they are investing in. This transparency provides investors with the ability to apply a portion of their investment dollars in a targeted way.
With the proliferation of ETFs, investors and advisors are increasing their use of them for a portion of their investment dollars. Using ETFs and mutual funds together offers investors more choices to develop an investment portfolio that best suits their investment needs.
ETF shareholders should be aware that the general level of stock or bond prices may decline, thus affecting the value of an exchange-traded fund. Although exchange-traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the funds may not be able to exactly replicate the performance of the indexes because of fund expenses and other factors.
All investing involves risk and you may incur a profit or a loss. There is no assurance that any investment strategy will be successful. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investments mentioned may not be suitable for all investors. Past performance is not a guarantee of future results. Any opinions are those of James Hyre and not necessarily those of RJFS or Raymond James.