​The ABCs of ETFs

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Some readers have asked us why it might make sense to invest in an ETF instead of a traditional mutual fund. To help these investors, we’ll explore some of the overall advantages of ETFs, a category first launched in 1993 and that now includes nearly 2,000 funds tracking just about any asset imaginable, notes Kuen (Scott) Chan in a special report for Investing Daily’s The Complete Investor.

One advantage ETFs have over traditional open-ended mutual funds: they’re cheaper. They have lower expense ratios because it costs less to run an ETF than a mutual fund. And while trading costs can vary depending on the type of account, investors generally incur lower trading commissions.

ETFs also offer more flexibility. Investors can short them, place limit and stop orders, and in many cases buy or short options on them.

Moreover, every open-ended mutual fund shareholder who purchases or sells a fund on a particular day receives the same price, calculated only after the market closes. This limits how much control investors have over the price at which they buy or sell.

Another advantage is better transparency. ETFs generally report their portfolio holdings on a daily basis. Mutual funds typically provide such information only once a month or quarter.

ETFs also tend to be more tax efficient. When you buy or sell an ETF, you are trading with other investors, so it doesn’t require the fund to actually trade any stocks.

This gives you control over when you will be incurring any capital gains or losses from a sale.

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With an open-ended mutual fund, however, anytime an investor redeems cash, the fund manager must sell shares from the portfolio.

The capital gains from such sales are distributed to all shareholders at year-end and are taxable. In other words, a small number of shareholders can affect the tax situation of every other shareholder in the same fund.

ETF investors should note, however, that ETFs that invest in currencies, futures, and metals have their own set of tax rules, usually following those governing the underlying

For example, our SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) are both considered “collectibles” for capital gains tax purposes. This means that even long-term (held for one year or more) gains will be taxed at your ordinary income tax rate, up to a maximum rate of 28 percent.

By comparison, the maximum long-term capital gains rate on stocks for those in the very top tax bracket is 20 percent. Check with your accountant for more details.

It’s also worth taking a few minutes to learn more about the four main ways these popular investment vehicles are structured.

The great majority, such as ALPS Sector Dividend Dogs (SDOG), iShares Core High Dividend (HDV), and most others in our Model Portfolio, are open-end funds that offer exposure to stocks and bonds.

Open-end ETFs, regulated under the Investment Company Act of 1940 and also coming under the Securities Act of 1933 and the Securities Exchange Act of 1934, give shareholders strong protection.

Other advantages: they can offer automatic dividend reinvestment, derivatives, and securities lending, i.e., lending their shares to short sellers, who post collateral and pay a fee. Profits from this practice, which does involve a small degree of risk, can be passed down to shareholders in part or in full.

A far smaller number of ETFs are structured as unit investment trusts (UITs). These purchase fixed portfolios rather than actively trade the underlying securities and typically track a broad asset class like a large stock index.

The popular SPDR S&P 500 ETF (SPY) is an example. Since they don’t need investment managers, costs are kept down. However, they can’t engage in derivatives trading or securities lending, which limits flexibility.

UIT shares are redeemable –- they can be returned to the issuer for their net asset value instead of sold on the open market at the market price –- but only in very large blocks out of reach for most retail investors. Shareholders in UITs enjoy the same legal protections as investors in open-end funds.

ETFs that invest in commodities or currencies, such as SPDR Gold Shares and iShares Silver Trust are structured as grantor trusts and must hold a fixed (unmanaged) portfolio.

Shareholders directly own the assets in the trust in proportion to their number of shares. In the case of precious metals grantor trusts, profits from the sale of shares are taxed as collectibles, not capital gains.

But we don’t see that as a reason to avoid them.

Finally, exchange-traded notes (ETNs) are forward contracts that promise to pay the return of a given index, net the issuers’ expenses. Our Model Portfolio’s Alerian MLP Infrastructure (AMLP), issued by UBS ETRACS, is an example.

Essentially with an ETN, you’re purchasing debt (so it’s worth assessing an issuer’s credit-worthiness). However, the “principal” will fluctuate since the issuer promises to pay at maturity whatever the return of a given index is. ETNs are usually used for niche markets such as certain commodities and currencies.

Kuen (Scott) Chan is contributor and portfolio editor at the Leeb Group.

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About MoneyShow.com: Founded in 1981, MoneyShow is a privately held financial media company headquartered in Sarasota, Florida. As a global network of investing and trading education, MoneyShow presents an extensive agenda of live and online events that attract over 75,000 investors, traders and financial advisors around the world.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

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