ETFs, or exchange-traded funds, are similar to mutual funds. Both try to replicate the movement of a specific index. In addition to that, neither of them requires a portfolio manager to select stocks. Instead, they are passively managed.
However, ETFs are similar to stocks when it comes to buying and selling during the day. Their price changes throughout the day, and you can buy them on margin or sell them short. In contrast, mutual funds have only one price a day. That means that, if you decide to buy them after the market closes, you will have to use the next day’s closing price.
Even though ETFs track a particular index, sometimes they can cause the underperformance of that same index. This may happen because there are administrative costs involved. Also, some ETFs can have higher or lower market value. The principle of supply and demand determines this, and it applies to less heavily traded ETFs.
History of ETFs
After the Investment Act of 1940, mutual funds couldn’t participate in active trade during the day. However, the Securities and Exchange Commission could grant exemptions to all those who want to offer ETFs on the market.
The first ETFs that participated in the exchange were Toronto Index Participation Units in 1989. A few years later, in 1993, the American Stock Exchange introduces their own ETFs – “spiders” or SPDRs. Their main goal is to track the movement of the S&P 500 Index.
ETFs and Mutual Funds – technical contrast
Trading ETFs is more complicated than using mutual funds to buy and sell securities for cash.
Firstly, trading ETFs does not include cash exchange, in contrast to mutual funds. Therefore, there is a minimal chance of capital gains and the trade itself may not be a taxable event.
Second, an investor creates an ETF when he assembles a variety of security holdings in a portfolio. This participant then exchanges them with the ETF’s manager. In return, he gets large blocks of ETF shares. Those blocks are creation units, and the investor can keep them in his portfolio, or break them up and sell some shares to other investors.
Supply and demand directly influence the creation and redemption of creation units. However, investors should bear in mind that the competition affects the ETF prices. Because of that, most of them usually have similar prices to the NAV of the underlying securities.
If you looking into buying ETFs, you do not have to be a large investor. Individual investors can also participate, but they would need to buy them through a broker.
Benefits of ETF trading
- You can trade them throughout the day.
- They offer a high level of diversification. By trading ETFs, investors can hold a variety of securities in their portfolio.
- They are cheaper than mutual funds. In addition to that, they require passive management, and there is a chance of lower taxable distributions.
- By trading creation units for ETF’s index securities, you are participating in an in-kind trade. Therefore, there aren’t any cash lags or capital gains and losses.
- The investors can sell them short.
- No minimum investment requirements.
- No redemption fees if you happen to hold them for only a brief period.
Disadvantages of ETF trading
- You need to purchase them through a broker, and that requires a brokerage commission.
- Often, ETFs are composed of securities that have a similar behavior pattern. You would need to make other investments as well so that you could have a diversified portfolio.
- There is a chance of wide bid-ask spreads.
How to evaluate an ETF?
Before investing, it is vital to consider certain factors regarding your ETF of choice:
- Research the index it tracks, and see what it consists of.
- Check the history of the fund and its underlying index. It is essential to know their previous performances and when they were established.
- Understand the expenses and research the investing strategy.
- Make sure that you know how the ETF will be taxed. For example, gold bullion ETF has the maximum tax rate of 28%. In addition, a bond ETF is taxable because of the interest it pays. Lastly, ETFs that use futures contracts, as well as some commodity ETFs, may have both long-term and short-term capital gains.