An Exchange Traded Fund (ETF) is a security and investment vehicle that has attributes of both mutual funds and stocks. Like traditional mutual funds, ETFs enable investors to access a diversified pool of assets. Like stocks – and unlike traditional mutual funds - ETFs trade throughout normal trading hours on an exchange.
ETFs offer several benefits that may make them an attractive alternative to mutual funds. As with all other investment decisions, investors should seek their own financial, legal and tax advice prior to purchasing any securities.
ETFs as an Alternative to Mutual Funds
- Intraday Liquidity & Pricing and Trading Flexibility
ETFs can be bought and sold during normal trading hours at the then current market price, either through a full service or discount/online brokerage account. Mutual fund purchases and sales, by contrast, are executed once daily at the close of the trading day at their calculated net asset value (NAV). And, because ETFs trade like stocks, investors have the flexibility to buy on margin, sell short, employ different types of trade orders, and in some cases, use options strategies.
- Transparency of Holdings
ETFs typically disclose their holdings on a daily basis, while mutual fund holdings are generally disclosed less frequently, usually quarterly.
- Cost Effectiveness
Due to different distribution methods and often lower transaction costs, ETFs generally incur lower management expense ratios (MERs) than do mutual funds. There are, however, certain costs incurred in buying and selling ETFs, such as commissions, bid-ask spreads, etc.
- Tax Efficiency
Due to the “in-kind” redemption process they employ, ETFs can be more tax efficient than mutual funds for certain investors, depending on the circumstances. Redemption demands are often met through an exchange of securities rather than the cashing out of positions which is typically employed in the case of mutual fund redemptions. Any such sales of securities can incur taxable gains which would then typically be passed through to investors in the form of distributions. When ETF units are redeemed, they are exchanged for other securities in a transaction between the ETF provider and the ETF’s designated broker, thereby avoiding the need for any sale of securities.
At its most basic level, owning an ETF is like owning a single stock that represents a basket of securities. As such, the ETF provides access and exposure to most major asset classes, including equities, fixed income, commodities and currencies. The simplest ETFs are designed to replicate to the greatest extent possible and “passively” track the performance of an underlying index or benchmark. The index constituents – the basket – can be equities, bonds, futures contracts or a mix of different asset classes.
There are many different types of indices and it is important to understand how each is constructed.
ETFs have evolved over recent years to include those that do not track an underlying index or benchmark. Some are physically backed by commodities, while others are “actively managed” with the objective of providing above-benchmark returns or incorporating sophisticated “alternative” investment strategies. Rather than merely seeking to passively track an index, these types of ETFs try to achieve a specified investment objective using an active investment strategy. In some cases, these investment strategies are built into “customized” indices.
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