03) Exchange-Traded Funds: Features

by · October 16, 2010

Many Exchange-Traded Funds (ETFs) are made to track a specific index. Its performance, therefore, is similar to that of an index mutual fund. The following are the the general differences between the two:


Trading of ETFs Can Be Beneficial for Small Investors

ETFs can be traded on a stock exchange throughout the day just like any listed stock. Orders can be placed in a fashion similar to stocks, such as stop loss orders or limit orders. Investors also practice short-selling of ETFs. Prices of ETFs are close to their underlying net asset values (NAV) but are independent of it. Mutual Funds, on the other hand, are only bought and redeemed based on their NAV at the end of the trading day.

Most investors buy ETFs in board lots. This is because if fewer than a board lot is bought, it will become too costly for the investor. The investor also has the option to buy ETFs no matter where in the world it is sold. For mutual funds, it can only be purchased in the country where it was registered.

Dividends

An ETF pays out dividends from the underlying stocks every quarter. The underlying stocks itself pays out dividends throughout the quarter. The cash from the dividends are deposited in the brokerage account in the same way as the dividends of a regular stock. Reinvesting is also possible by making another purchase. Mutual funds dividends are normally paid out annually.

Tax Efficiency

Better tax benefits can be gained from an ETF compared to a mutual fund because it is passively managed. With a low turnover of securities, ETFs realize less capital gains compared to actively managed funds. Index ETFs generally sell securities only when its underlying index changes. Mutual funds instead collect the unrealized capital gains liabilities as the portfolio’s stocks value increase. When the stocks are then sold, the capital gains are divided proportionally to the owners’ investment resulting in bigger taxes.

It is Transparent

Compared to mutual funds, ETFs are more transparent. The investors can clearly see what they are buying with an ETF since each is designed to copy the performance of its underlying index. The fees are also laid out in an obvious manner. Mutual funds are not as transparent because reports only come two times a year.

Fees and Commissions

Since ETFs are passively managed the marketing, distribution and accounting expenses are lower which results in smaller fees. The only other added cost is the commission paid to the broker every time an investor trades ETF shares. If shares are constantly being traded, this results in more commissions, so the cost of the ETF investment becomes higher. However, discount brokers with lower commission fees, tend to make the frequent trading of ETF more bearable in terms of cost.

Options

ETFs also have options that can be traded allowing investors more leverage in their portfolios. This is being used by many investors as a different investment strategy.