Exchange Traded Funds (ETFs) can be an efficient way for investors to own a portfolio of stocks or bonds. Each share represents a fractional ownership interest in a professionally managed investment portfolio. Those shares are listed on an exchange and can be bought and sold like a stock[1]. This article examines these and other benefits of ETFs.
How an ETF’s Structure is Beneficial to Investors
The two distinguishing characteristics of ETFs are straightforward. They are pooled investment funds that trade like stocks. But a closer look into these characteristics reveals five distinct benefits ETFs offer investors.
- Tax Efficiency
- Liquidity
- Transparency
- Diversification
- Low Fees
Tax Efficiency
Tax efficiency means that something produces a favorable tax outcome. ETFs are tax efficient for two reasons:
- Low turnover
- Shareholder sales don’t impact other shareholders
ETFs have low turnover because they typically track specific market indexes, like the S&P 500. The securities in an index don’t change very often. So, an ETF’s holdings don’t either. Low turnover translates to limited taxable gains.
Shareholders who sell ETF shares do so on an exchange. Their shares are sold to other investors – not the fund.
Since the fund doesn’t need to sell portfolio securities to pay shareholders who are redeeming their shares, it doesn’t generate taxable gains. If the fund incurs capital gains, it has to pass them, along with their liability to remaining shareholders.[2] This adds to the tax efficiency of an ETF.
Liquidity
Liquidity means buying or selling shares quickly without significantly influencing price. ETF transactions typically settle in two days. So, they are nearly as liquid as common stocks.[3]
Moreover, ETFs trade on exchanges where securities are bought and sold daily on a routine and dependable basis.
Transactions in ETFs occur almost instantly and sale prices are immediately available for anyone to see. After a sale, proceeds are generally available in two days.
Transparency
Market efficiency and required reporting help deliver transparency to ETF investors.
ETFs are required to publish their Net Asset value (NAV) at the end of every day the market is open.
ETFs report their holdings daily (unlike most mutual funds, which are only required to report quarterly.) They must also include a description of their holdings.
That description must include the quantity of each security held and its percentage weight of the portfolio, including its ticker symbol or other identifier, whether it’s a stock or a bond (in which case, its maturity date, coupon rate, and effective date are required), the quantity of it held and its percentage weight of the portfolio.
Throughout the trading day, ETFs must also report an estimate of their NAV almost continuously.[4]
When transactions take place, prices usually correspond closely to the fund’s NAV and are automatically reported.
All of this contributes to the transparency of ETFs.
Diversification
Diversification means owning different asset classes (e.g., stocks, bonds) as well as having multiple securities within those asset classes.
These techniques reduce risk by spreading it around. Diversification decreases the risk that a loss in one security or holdings in one asset class could hurt a portfolio’s overall performance.[5]
Professional investment managers are good at diversifying portfolios by owning multiple securities. This is how ETFs can help provide portfolio diversification to shareholders.
Low Fees
ETFs typically have low expense ratios. Most ETFs are passively managed or rules based, which reduces management fees. Their generally low portfolio turnover also helps keep overall operating costs low.
Potential Risks of ETFs
Some of the potential risks of ETFs include market risk, asset exposure risk and trading risk.
Market risk means that an ETF can lose value when the market (stock or bond) declines.
Asset exposure risks are related to the specific assets in a given ETF’s portfolio. Some are riskier than others.
Trading risk is related to buying and selling. Trading may create unintended losses and can rack up additional brokerage commissions.
Working with experienced financial professionals can help you stay the course. They can provide guidance and encouragement to help focus your attention on your long-term goals.
[1] When comparing stocks or bonds and ETFs, it should be remembered that management fees associated with fund investments, like ETFs, are not borne by investors in individual stocks or bonds.
[2] Capital gains distributions may be lower for ETFs that seek to track an index, but there is no guarantee that ETFs will not distribute capital gains to shareholders. Buying and selling shares on the exchange may generate tax consequences.
[3] Not all ETFs are highly liquid. An ETF’s liquidity depends on the assets in its underlying portfolio, which may not be easily bought or sold.
[4] Estimated NAV is reported as Intraday Indicative Value (IIV) or Intraday Operative Value (IOPV) depending on the exchange on which the ETF is listed approximately every 15 seconds.
[5] Diversification is no guarantee against loss in a declining market.
