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Inside ETFs

Learn the basics—including the benefits and risks—of investing in exchange-traded funds.

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Not long ago, exchange-traded funds, or ETFs, were the new kid on the investment block. Not anymore.

Now, you can choose from nearly 1,400 different ETFs/ETPs, with assets exceeding $1 trillion. And while the early ETFs tracked broad market indexes like the S&P 500® Index, now there are ETFs focused on virtually every imaginable corner of the market—from health care to solar energy, from Treasury bonds to emerging market debt, from commodities to currencies, and from Turkey to Thailand. You can also find style-based ETFs focused on growth, value, or capitalization, or theme-based ETFs, such as those aimed at green or socially responsible investors.

But like any investment vehicle, ETFs have risks along with potential rewards. Understanding the difference is a key to success. So, how exactly do they work? What are their pros and cons? And how might they fit into your investment style and strategy?

The basics

Essentially, ETFs are baskets of securities that trade like stocks on an exchange. As with index mutual funds, many ETFs track an index, and those indexes can be very broad or extremely narrow.

But the way ETFs are priced, and bought and sold, differs from mutual funds. A mutual fund may be purchased or sold only at a price based on the net asset value (NAV) of the fund, which is typically determined once a day and is based on the closing price of all the securities in the portfolio at the end of the trading day. You buy and sell mutual fund shares either directly from the fund company or through a broker. By contrast, you buy and sell ETFs, like stocks listed on a stock exchange, through your brokerage account throughout the trading day. When you wish to buy or sell shares of an ETF, you are presented a bid and ask price for the shares, as you are with an individual stock. Also as with stocks, the price at which an ETF trades varies throughout the day.

With ETFs that trade frequently and track very liquid underlying securities, like the large-capitalization stocks in the S&P 500® Index, the price of the ETF and value of the securities in the fund tend to track closely. However, the price of an ETF that holds less liquid securities—like certain types of fixed-income securities or stocks traded on a small foreign market that is closed during U.S. trading hours—could vary more significantly from the net asset value of the securities in the ETF.

The pros—plus some caveats

ETFs have many appealing features for both long-term investors and short-term traders, although there are some potentially dangerous pitfalls to avoid for both investor types. Here are some of the main advantages, with a few caveats.

Diversification: Unlike individual stocks or bonds, many ETFs represent a portfolio of securities. For this reason, they can be an easy way for individual investors to build a well-balanced strategic asset allocation of stocks and bonds, as well as alternative asset classes, including commodities, real estate, and even currencies. ETFs can also be an effective way to fill a gap in a well-balanced portfolio or to make more targeted investment decisions—say, on gold, financial services stocks, or emerging market debt—without having to pick individual securities or commodities.

Caveat: Not all ETFs are successful in tracking their index (benchmark) closely. If you are using an ETF for exposure to a particular index and your ETF is not tracking it closely, you may not be getting what you paid for. In addition, other ETFs have emerged with a narrower focus. They may give you access to varying styles, sectors, or regions, but can be limited in their diversification benefits. For example, some country-specific ETFs offer you exposure but through a limited number of stocks associated with the ETF’s corresponding country index.

Low cost: Expense ratios for many index ETFs are low compared to actively-managed mutual funds that focus on similar areas of the capital markets. The main cost advantage of index-based ETFs stems from the fact that they generally don’t attempt to outperform the market like actively managed funds or ETFs do. In investment terminology, index-based ETFs are all about beta, not alpha, so fund companies don’t need to hire analysts to research the companies that are likely to outperform their indexes. Nor do ETFs have investment minimums or fees for early redemptions, although it should be noted that certain brokers may impose early redemption fees.

Caveat: Of course, on most ETFs you will pay a commission and bid-ask spread (the difference in price between the market price for buying the ETF and the market price for selling the ETF), which can erode any cost advantage ETFs may have relative to mutual funds. Furthermore, with the explosive growth of ETFs, not all are low cost. For example, some narrowly focused ETFs have significantly higher expense ratios than you’d expect. In addition, there is a trend toward more actively managed ETFs, which brings with it higher expense ratios. Lastly, some ETFs that hold less liquid positions can have wide bid-ask spreads, which can further add to the investment costs. In general, if you are likely to hold the ETF for only a short period of time, all other factors being equal, look for ETFs that have low bid-ask spreads, typically those under 0.25% of the share price.

Easy to trade: While you typically have to wait until the end of the day for your mutual fund trade to be completed, ETFs can be traded any time during the day. That can be an advantage, particularly in fast-moving markets. Also, you can set stop, limit, and other order types with ETFs, just as with stocks. This can help you purchase an ETF at or near your desired price, or help limit your downside risk if the market moves against you. Finally, apart from a single share purchase, ETFs have no investment minimums, unlike mutual funds, which typically have account minimums of $2,000 to $3,000. Investors can buy any number of shares of an ETF.

Caveat: While mutual funds trade at their net asset value, ETFs can trade above or below the NAV of the underlying portfolio of securities. When markets are functioning normally, or if the ETF is composed of highly liquid securities, the ETF should trade at a market price at or near the NAV of the underlying securities. However, at other times, such as during periods of market turmoil, or if an ETF is composed of less liquid securities, premiums and discounts can develop. One way to understand whether an ETF is accurately valued against its underlying securities is to look at the intraday indicative value (IIV) for the ETF. The IIV is designed to give investors a sense of the relationship between a basket of securities that are representative of those owned in the ETF and the share price of the ETF on an intraday basis. The IIV is updated by the listing exchange every 15 seconds and provides the investor a way to compare the market price with the ETF portfolio’s net asset value any time during market hours. Liquidity is another important factor when considering the ease of trading an ETF. Highly liquid ETFs are generally easier to buy and sell.

Transparency: Because many ETFs track an index, it’s relatively easy to know exactly what you own. Each index-based ETF is required to publish its holdings and weightings daily. As an investor, owning an index-based ETF lets you become familiar with the positions and weights in the relevant index as well as the ETF. This can help you identify any overlap across your portfolio and provide you with timely risk measurements associated with the ETF’s holdings. Mutual funds also publish their holdings and allow investors to identify any overlap across their portfolios, but just not as frequently. A mutual fund typically publishes its holdings every one to three months, depending on the fund’s investment policy.

Caveat: In general, ETFs are either index-based or actively managed ETFs. As with mutual funds, actively managed ETFs don’t seek to “track” their benchmark (they seek to outperform it). Although you will still have visibility into the actively managed ETF holdings, you will need to make sure your portfolio continues to be invested consistent with your overall risk tolerance and asset allocation strategy. In addition, because the expense ratio generally may be higher on active ETFs than on passive, index-based ETFs—and expenses decrease fund returns—if you have an actively managed ETF, you will want to make sure that you are getting the right level of return for the additional risk you are taking.

Tax efficiency: Although both ETFs and mutual funds are required to distribute capital gains annually, ETFs may be more tax efficient than similar mutual funds. Why? As we mentioned above, ETF investors can only redeem ETF shares on an exchange and they can’t redeem their shares directly with the fund. When faced with redemption requests from investors, ETF managers usually do not have to sell individual securities in order to meet these redemption requests. Instead, the ETFs can deliver baskets of their underlying portfolio’s stocks “in-kind,” rather than cash, to large investors, known as authorized participants or “APs.” APs deal directly with the ETF and in this regard work like a clearinghouse, matching the shares of the underlying securities when redemptions come in with those required to meet the demand of new investors. ETF managers can use this in-kind redemption process to remove the stock shares from the portfolio with the lowest cost basis, limiting the ETF’s potential for distributing gains. Additionally, since most ETFs closely track their underlying index, their trading activity tends to be low, as with index funds. ETFs typically generate a lower level of capital gain distributions relative to actively-managed mutual funds. It is important to understand the fund structure and associated tax treatment before investing.

Caveat: While capital gains distributions are often lower with ETFs than with similar mutual funds, this is not always the case. Also, some ETFs kick off ordinary income. So, if you are considering such income-generating ETFs, a tax-deferred retirement account may be the best place to hold them.

The cons

For all the advantages of ETFs, there are shortcomings as well. As with index mutual funds, index-based ETFs do not attempt to outperform their benchmark index. That’s the potential upside of actively managed funds or ETFs—and why investors may be willing to pay more for these instruments.

Also, keep in mind that leveraged and inverse ETFs are not designed for buy-and-hold investors who are trying to track an index over a long period of time. Rather, these investments are intended for very aggressive, sophisticated investors who actively manage their investments on a daily basis. Due to the effect of compounding, leveraged and inverse ETFs are not likely to track the performance of a benchmark index over extended periods. Therefore, holding them long term may entail considerable and unnecessary risk.

Finally, with the tremendous growth associated with ETFs, investors should be aware there are “costs” associated with the benefits of ETFs. Before you invest, you should do your due diligence to understand the structure of the ETF and its associated risks and tax implications. Many investors may not be aware that some products commonly referred to as ETFs are not funds at all. An example of this is exchange-traded notes, or ETNs. These products have counterparty risk because they are notes or structured debt, while others are set up as partnerships, which can mean greater tax complexity. Shareholders may be required to file state tax returns in multiple states.

Be careful to balance the benefits of access and flexibility with the cost and complexity that may be inherent in some types of ETFs. Above all, investors considering an ETF should take the time to read its prospectus in order to better understand its investment strategy and potential risks.

How to use ETFs

Are ETFs right for you? That will depend on your goals, level of investing experience, and investing style. Also, with so many choices, it’s critical to determine which type of ETF best fits your overall strategy.

Are you getting started with investing? Having an appropriate mix of investments—also known as asset allocation—can be a critical factor in the overall performance of your portfolio. How you determine your asset allocation depends largely on your comfort with risk and the time frame for your investments. Generally, the younger you are, the more risk you can afford to take with your investments. As you get older, you may be less interested in growth and more interested in protecting the value of your portfolio. Once you determine the right mix of stocks, bonds, and cash, identifying which ETFs to buy to build a well-diversified portfolio can be straightforward.

Are you looking to fill some gaps in your portfolio? Even if your basic asset allocation is well structured, you may have some gaps you’d like to fill. Perhaps you want exposure to some extended asset classes, such as commodities or REITs. An ETF can be a cost-effective solution that helps you target and diversify within a particular part of the market.

Are you confident about your market outlook? If you have a strong conviction on a particular style—growth or value—or sector of the market and you want to make a tactical investment with a small portion of your portfolio, an ETF can be a useful investment tool. ETFs enable you to get in and out of the market intraday. Some short-term traders employ sophisticated charting techniques to determine when to buy and sell an ETF. While this is not a suitable investment strategy for long-term investors, it demonstrates another way that ETFs are currently being utilized in the market.

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Free commission offer applies to online purchases of 65 iShares© ETFs and Fidelity ETFs in a Fidelity brokerage account with a minimum opening balance of $2,500. The sale of ETFs are subject to an activity assessment fee (of between $0.01 to $0.03 per $1000 of principal) by Fidelity. After September 30, 2013, 65 iShares ETFS are subject to a short-term trading fee by Fidelity, if held less than 30 days. After January 31, 2014, Fidelity ETFs are subject to a short-term trading fee by Fidelity, if held less than 30 days.
Beta is the sensitivity of an investment’s returns to the returns on some market index (e.g., S&P 500). Alpha is a measure of residual return of an investment relative to some market index.
Diversification does not ensure a profit or guarantee against loss.
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