Most investors understand what stocks are and how they work. A lot of investors also know about exchange-traded funds (ETFs), which trade like stocks in that they are available to buy and sell while the market is open but typically mimic a basket of securities similar to index mutual funds. However, there are some prevalent misconceptions associated with ETFs. Here, we explain five facts of ETFs that may surprise you.
|Fact #1:||Not all ETFs are cheap.|
Most ETFs are less expensive than actively managed funds. The average expense ratio (i.e., the management fee for operating the fund) for all ETFs is less than 0.57%, versus about 1.5% for actively managed funds.1 Moreover, expenses are even lower for many widely used ETFs: The average expense ratio for U.S. stock ETFs is 0.35%, compared with 1.33% for U.S. stock mutual funds.1 It is worth noting that 1.33% is the average expense ratio for both active and passive funds, and there are many more active than passive funds.
But it’s a mistake to assume that all ETFs are cheaper.
For example, mutual fund Spartan® 500 Index Fund—Fidelity Advantage Class (FUSVX) has an expense ratio of 0.05%, and it has no transaction fee on Fidelity.com.2 That compares favorably with similar ETFs, such as the SPDR S&P 500 ETF (SPY) with an expense ratio of 0.09%. The iShares Core S&P 500 ETF (IVV) has an expense ratio of 0.07%, but has the added benefit of being among 70 iShares® ETFs that are available for purchase commission-free on Fidelity.com. This example assumes a minimum $10,000 investment in the Spartan Fund; ETFs do not require a minimum investment.
It’s worth noting that expense ratios aren’t the only thing to consider when evaluating ETF costs. Tracking error, which is a measure of how well the ETF tracks the index, can affect the total return of an ETF. If you are looking to simply emulate the performance of a benchmark, like the S&P 500® Index, it may be prudent to seek out ETFs with low tracking error.
Bid-ask spread is another factor that can affect your total cost. An ETF with a wider bid-ask spread—the difference in price between what a buyer is willing to pay and what a seller is willing to sell—may be more costly, all else being equal. You can find an ETF’s bid-ask spread, along with its tracking error and other trading costs, on Fidelity.com on an ETF’s snapshot page.
|Fact #2:||ETFs can pay dividends.|
If a stock is held in an ETF and that stock pays a dividend, then so, too, does the ETF.
While some ETFs pay dividends as soon as they are received from each company that is held in the fund, most distribute dividends quarterly. Some ETFs hold the individual dividends in cash until the ETF’s payout date. Others reinvest the dividends back into the fund as they are received, and then distribute them as cash on the ETF’s payout date.
ETFs may provide the option of forgoing receiving cash in exchange for the purchase of new shares with the dividends received. And certain brokers, including Fidelity, might allow you to reinvest dividends commission free. You can find out if and how an ETF pays a dividend by examining its prospectus.
|Fact #3:||All ETFs are not passive.|
Most ETFs track an index, such as the S&P 500® Index. These types of investments are considered “passively managed”: Any purchases or sales of securities by the fund are made to keep the portfolio in line with the index it attempts to track. As previously mentioned, tracking error is a metric that can help you see how well an ETF replicates the performance of an index.
"Smart beta" ETFs are a growing category of ETFs that are passively managed, however, they seek to either improve their return profile or change their risk profile, relative to a benchmark. This is accomplished by tilting one or more factors of the corresponding benchmark, such as increasing or decreasing exposure to growth or value characteristics. The largest smart beta ETF, as of March 2016, is the iShares Russell 1000 Growth ETF (IWF), per Fidelity.com. As of the end of 2015, nearly a third of all assets flowing into ETFs went to smart beta ETFs, according to ETF.com.
There are some ETFs that, by design, do not strictly track an index. Instead, they are actively managed with the goal being to outperform a benchmark like the S&P 500. The fund manager for an actively managed ETF may choose to hold different securities, and/or in different weights versus those of the index that the ETF seeks to outperform.
In the United States, active ETFs have grown to approximately $17 billion in assets; however, active ETFs account for only a small percentage of the over $2 trillion ETF universe.3 To date, the majority of actively managed ETFs have had a fixed-income focus.
|Fact #4:||Not all ETFs are tax efficient.|
Taxes are an important consideration for any investment. In general, ETFs are considered tax efficient compared with actively managed funds due to their unique structure, generally lower portfolio turnover, and how they are managed. One of the primary advantages of the ETF structure is that when an investor buys or sells shares of the ETF, the ETF administrator can match purchases and sales with other investors so that no actual security purchases inside the fund need to be made.
With that said, not all ETFs are absolutely tax efficient.
For example, ETF dividends are subject to taxes, and ETFs that pay nonqualified dividends may be less tax efficient than those that pay qualified dividends. Annual distributions from an ETF to investors may be treated as qualified or nonqualified dividends. Qualified dividends are taxed at no more than 15%. However, just because the ETF reports that its distribution was a qualified dividend, that does not automatically make it qualified for the investor. The investor must have held the ETF for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date.
It may be possible to invest tax efficiently with ETFs by selecting those that minimize capital gains distributions and maximize exposure to qualified dividends. If minimizing taxes is a concern, consider consulting a qualified tax advisor. And make sure to evaluate any investment option with your time horizon, financial circumstances, and tolerance for risk in mind.
|Fact #5:||Not all ETFs are highly liquid.|
A primary advantage of ETFs, compared with other funds, is their flexibility—continuous pricing and the ability to place limit orders. However, these characteristics do not ensure that all ETFs are highly liquid, meaning you are able to buy or sell at or near your desired price.
There are several ways you can find highly liquid assets—including ETFs. As previously mentioned, a low bid-ask spread may indicate a robust market of buyers and sellers. Average daily volume is another indicator of liquidity. Volume is the number of shares traded: Investments with high volume and, consequently, greater liquidity, tend to be more efficient.
For example, iShares Core S&P 500 ETF (IVV) has a bid-ask spread one-month average of 0.01%, which is as low as this spread can be. Some more narrowly focused ETFs have much wider bid-ask spreads, which could cause trading in them to be relatively more expensive. Additionally, IVV is in the top quintile of 90-day average volume among ETFs.
A few last tips
Once you have identified an ETF in the asset class, sector, or region of the market that you want to invest in, you can use a tool like an ETF screener, for example, to find ETFs in this space with your desired attributes, such as a low average daily bid-ask spread and high average daily trading volume.
Other tools, like Fidelity’s ETF research page, can help investigate additional characteristics of an ETF you are analyzing, including the underlying fundamentals of the stocks within the fund. Once you home in on an ETF that looks attractive to you, it may also be beneficial to utilize limit orders when placing a trade to ensure that you are executing at a price you are comfortable with.
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