For nearly a century, traditional mutual funds have offered many advantages over building a portfolio one security at a time. Mutual funds provide investors broad diversification, professional management, relative low cost, and daily liquidity.
Exchange-traded funds (ETFs) take the benefits of mutual fund investing to the next level. ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts. There are drawbacks, however, including trading costs and learning complexities of the product. Most informed financial experts agree that the pluses of ETFs overshadow the minuses by a sizable margin.
Positive aspects of ETFs
ETFs have several advantages over traditional open-end funds. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs, and tax benefits.
Traditional open-end mutual fund shares are traded only once per day after the markets close. All trading is done with the mutual fund company that issues the shares. Investors must wait until the end of the day when the fund net asset value (NAV) is announced before knowing what price they paid for new shares when buying that day and the price they will receive for shares they sold that day. Once-per-day trading is fine for most long-term investors, but some people require greater flexibility.
ETFs are bought and sold during the day when the markets are open. The pricing of ETF shares is continuous during normal exchange hours. Share prices vary throughout the day, based mainly on the changing intraday value of the underlying assets in the fund. ETF investors know within moments how much they paid to buy shares and how much they received after selling.
The nearly instantaneous trading of ETF shares makes intraday management of a portfolio a snap. It is easy to move money between specific asset classes, such as stocks, bonds, or commodities. Investors can efficiently get their allocation into the investments they want in an hour and then change their allocation in the next hour. That is not generally recommended, but it can be done.
Making changes to traditional open-end mutual funds is more challenging and can take several days. First, there is typically a 2:00 pm Eastern standard time cutoff for placing open-end share trades. That means you do not know what the NAV price will be at the end of the day. It is impossible to know exactly how much you will receive when selling shares of one open-end fund or know how much you should buy of another open-end fund.
The trade order flexibility of ETFs also gives investors the benefit of making timely investment decisions and placing orders in a variety of ways. Investing in ETF shares has all the trade combinations of investing in common stocks, including limit orders and stop-limit orders. ETFs can also be purchased on margin by borrowing money from a broker. Every brokerage firm has tutorials on trade order types and requirements for borrowing on margin.
Short selling is also available to ETF investors. Shorting entails borrowing securities from your brokerage firm and simultaneously selling those securities on the market. The hope is that the price of the borrowed securities will drop and you can buy them back at a lower price at a later time.
Portfolio diversification and risk management
Investors may wish to quickly gain portfolio exposure to specific sectors, styles, industries, or countries but do not have expertise in those areas. Given the wide variety of sector, style, industry, and country categories available, ETF shares may be able to provide an investor easy exposure to a specific desired market segment.
ETFs are now traded on virtually every major asset class, commodity, and currency in the world. Moreover, innovative new ETF structures embody a particular investment or trading strategy. For example, through ETFs an investor can buy or sell stock market volatility or invest on a continuous basis in the highest yielding currencies in the world.
In certain situations, an investor may have significant risk in a particular sector but cannot diversify that risk because of restrictions or taxes. In that case, the person can short an industry-sector ETF or buy an ETF that shorts an industry for them.
For example, an investor may have a large number of restricted shares in the semiconductor industry. In that situation, the person may want to short shares of the Standard & Poor's (S&P) SPDR Semiconductor (XSD). That would reduce one's overall risk exposure to a downturn in that sector. XSD is an equal-weighted market cap index of semiconductor stocks listed on the New York Stock Exchange, American Stock Exchange, NASDAQ National Market, and NASDAQ Small Cap exchanges.
Operating expenses are incurred by all managed funds regardless of the structure. Those costs include, but are not limited to, portfolio management fees, custody costs, administrative expenses, marketing expenses, and distribution. Costs historically have been very important in forecasting returns. In general, the lower the cost of investing in a fund, the higher the expected return for that fund.
ETF operation costs can be streamlined compared to open-end mutual funds. Lower costs are a result of client service–related expenses being passed on to the brokerage firms that hold the exchange-traded securities in customer accounts. Fund administrative costs can go down for ETFs when a firm does not have to staff a call center to answer questions from thousands of individual investors.
ETFs also have lower expenses in the area of monthly statements, notifications, and transfers. Traditional open-end fund companies are required to send statements and reports to shareholders on a regular basis. Not so with ETFs. Fund sponsors are responsible for providing that information only to authorized participants who are the direct owners of creation units. Individual investors buy and sell individual shares of like stocks through brokerage firms, and the brokerage firm becomes responsible for servicing those investors, not the ETF companies.
Brokerage companies issue monthly statements, annual tax reports, quarterly reports, and 1099s. The reduced administrative burden of service and record keeping for thousands of individual clients means ETF companies have a lower overhead, and at least part of that savings is passed on to individual investors in the form of lower fund expenses.
Another cost savings for ETF shares is the absence of mutual fund redemption fees. Shareholders in ETFs avoid the short-term redemption fees that are charged on some open-end funds. For example, the Vanguard REIT Index Fund Investor Shares (VGSIX) has a redemption fee of 1% if held for less than one year. The Vanguard REIT ETF (VNQ) is the exact same portfolio and has no redemption fee.
ETFs have 2 major tax advantages compared to mutual funds. Due to structural differences, mutual funds typically incur more capital gains taxes than ETFs. Moreover, capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor, whereas mutual funds pass on capital gains taxes to investors through the life of the investment. In short, ETFs have lower capital gains and they are payable only upon sales of the ETF.
The tax situation regarding dividends is less advantageous for ETFs. There are 2 kinds of dividends issued by ETFs, qualified and unqualified. In order for a dividend to be classified as qualified, the ETF needs to be held by an investor for at least 60 days prior to the dividend payout date. The tax rate for qualified dividends varies from 5%–15% depending on the investor's income tax rate. Unqualified dividends are taxed at the investor’s income tax rate.
Exchange-traded notes, which are thought of as a subset of exchange-traded funds, are structured to avoid dividend taxation. Dividends are not issued by ETNs; however, the value of dividends is reflected in the price of the ETN.