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What Is an ETF – Exchange Traded Funds Definition, Types, Pros & Cons

By Jason Van Steenwyk

etf investingIf you’re a buy and hold, long-term investor looking to build a portfolio, exchange-traded funds (ETFs) are worth a look. They have a number of advantages over mutual funds, and you can buy ETFs that focus on nearly any market you can imagine.

However, before investing, it’s important to understand ETFs. Learn how they differ from mutual funds, and investigate their advantages and disadvantages relative to conventional mutual funds.

What Is an ETF?

Open-End vs. Closed-End Mutual Funds

As you may already understand, a mutual fund is an arrangement in which investors pool their money and hire a portfolio manager to buy and sell securities on their behalf. With traditional open-end mutual funds, investors can buy or sell shares directly from the fund company itself. Closed-end fund shares, however, are traded over exchanges just like a stock, and are typically purchased from other shareholders.

Unless the fund company is buying back shares, or selling founding shares to its initial subscribers, the fund company itself is not involved with secondary market transactions. However, just as with open-end mutual funds, you still have a fund manager (or a team of managers) trying to buy and sell securities on shareholders’ behalf.

One key difference: When you buy open-end funds, your counterparty (who you buy from) is always the fund company itself. They will buy or sell shares at their net asset value (NAV) as of the market close at the end of the day. If you buy them after markets open, you get the fund’s closing price for that business day. If you buy them after markets close for the day, you get the price as of the close of the next business day.

With closed-end funds and exchange-traded funds, on the other hand, your counterparty isn’t normally the fund company itself, but other shareholders who buy or sell shares all day long, either directly or, more commonly, over stock exchanges. You can buy and sell shares at whatever price you can find a willing buyer or seller.

ETFs and Closed-End Funds

ETFs are close cousins to closed-end funds. Like closed-end fund shares, ETF shares can be bought and sold over stock exchanges, just like any other stock. The primary difference is that ETFs are not actively managed. Instead, the securities in an ETF portfolio are simply a basket of securities designed to replicate an index as closely as possible.

For example, an S&P 500 index fund owns shares of companies in the Standard & Poor’s 500 list of the biggest publicly traded companies on the New York Stock Exchange – as listed by market capitalization. You can buy shares in an open-end S&P 500 fund, such as the Vanguard 500, or you can buy the ETF version, also called a SPDR (“spider”). Think of ETFs as closed-end index funds, traded over stock exchanges.

etf coins

Advantages of ETFs

1. Cost
Because ETF shareholders don’t need to pay a manager and a team of analysts and brokers to buy and sell funds on their behalf, nor to manage fund inflows and outflows, exchange traded funds typically have much lower expense ratios than traditional mutual funds. Their expense ratios also tend to be lower than open-end index funds, because even open-end index funds have to keep enough staff on hand to process constant purchases and redemptions.

For example, many large cap mutual funds charge expense ratios of 80 basis points, or 0.8% per year, or more. Investor shares of open-end mutual funds typically have an expense ratio of 18 to 50 basis points, depending on the index. Investor shares of large cap index funds, such as S&P 500 index funds, will typically charge 18 to 20 basis points. But large-cap ETF may charge around 10 to 15 basis points, on an ongoing basis.

However, you do need to account for the cost of trading as well. When you buy or sell an ETF or closed-end fund, you will generally need to pay a commission to a broker – though some low-cost online brokerages have commission charges as low as $4 per trade. With open-end funds, you may also be assessed an additional sales charge, typically for between 5.85% and 6.2% for “Class-A” shares if you go through a full-service broker or financial advisor.

That said, you can also buy shares in a “no-load” mutual fund directly from the fund company without paying a commission.

2. Liquidity
When you buy an open-end mutual fund, you can only buy fund shares once per day, at their net asset value as of the last market close. You can’t buy or sell shares during the day: If you own an open-end fund and you hear disastrous news in the morning after the markets open, you cannot sell until after 4pm EST that afternoon. Likewise, you cannot buy on good news. All purchases don’t get logged until after 4pm the following day.

ETFs and closed-end mutual funds can both be sold throughout the day over the stock exchanges, though some funds are more frequently traded than others. The more frequently the fund is traded, the easier it generally is to find a willing buyer or seller in a hurry.

3. Short Selling
With open-end funds, you can’t engage in short selling, the practice of borrowing shares and selling them in the expectation that share prices will fall. If prices fall, the short seller buys back the shares at the new price and returns them to the original owner, keeping the difference. However, you can short industries, countries, and entire markets using ETF shares.

4. Tax Considerations and Low Turnover
Index funds, including ETFs, tend to be very tax efficient and ideal for holding in taxable accounts. This is because portfolio turnover in index funds is very low, whereas managers of actively managed funds sell securities and buy new ones every time they have a better investment idea. Index funds and ETFs, on the other hand, only sell shares when new securities get dropped from the index, and buy shares only when they are added to the index.

Every time a fund sells a share at a profit, the IRS assesses capital gains tax – which gets passed on to shareholders. Since index funds and ETFs don’t sell shares very often, it is very rare for them to generate a taxable distribution for their shareholders.

5. Lack of Redemptions
ETFs are usually slightly more tax-efficient than open-end index funds, because ETFs don’t have to concern themselves with selling shares to meet redemptions. That function is served by the open market; the ETF’s staff is out of the picture.

6. In-Kind Distributions
ETFs also have the option of making an “in-kind” distribution to shareholders. This means they can send securities from the portfolio directly to shareholders and let them sell them themselves if they want the cash. This helps shelter the fund’s remaining shareholders from the tax consequences of the sale.

However, if the ETF’s portfolio generates dividend income, this income is taxable, just as it is with closed-end and open-end mutual funds.

7. No Cash Drag
Index fund portfolios try to replicate an index as closely as possible. As a result, they typically own very little cash in their portfolios. They are 100% fully invested at all times. This works in their favor in rising markets. ETFs have no concern with meeting redemptions, so they can afford to have almost no cash on hand. In falling markets, however, a low cash position hurts the fund – the portfolio bears the full brunt of the market decline.

Disadvantages of ETFs

1. Small Discounts
When fund shares get traded in the open market as opposed to being redeemed directly from the fund company itself, it is investors that determine share prices. This price can be higher or lower than the aggregated value of the shares in the portfolio. With closed-end funds, it is frequently possible to buy fund shares at a 5% to 15% discount to net asset value. But the shareholder gets the full benefit of any dividends or interest payments from the fund and the potential for capital appreciation if discounts narrow.

With ETFs, on the other hand, discounts are typically either extremely narrow or non-existent. Investors seeking to benefit from buying fund shares at a discount may be better off going with an actively managed closed-end fund rather than an ETF. This is particularly true for income-oriented investors.

2. No DRIPs
Many investors like to have dividends automatically reinvested in fund shares, in a DRIP, or dividend reinvestment plan. However, this is usually not done with ETFs, as it would require too much fund administration and drive up fund costs.

A big part of the logic of ETF investing is the low-cost structure of ETFs. When you buy ETFs, expect to receive your dividends and interest payments directly, and to pay taxes on them if you don’t hold them in an IRA or other tax-advantaged account.

stocks

Types of ETFs

There’s an ETF for nearly every purpose. Here are some of the most common types:

  1. Long ETFs. These take a “long position” on their underlying indexes. They typically own shares of companies in a specific index. If the index rises, so do share prices in long ETFs, by about the same amount, minus any expenses and trading costs.
  2. Inverse ETFs. The opposite of long ETFs. They take “short positions” on the underlying index. Share prices move in the opposite direction to ETF shares. If the index loses money, you win.
  3. Gold ETFs. These ETFs invest in a representative sample of gold stocks, or they hold claims on actual gold bullion, held in trust by a custodian. Shares in gold ETFs typically move in rough tandem with gold prices. You can also buy ETFs that focus on precious metals more generally.
  4. Industry ETFs. These ETFs own a portfolio of stocks representing an industry, such as energy and oil, technology, mining, transportation, health care, and so on.
  5. Country ETFs. These investments buy shares in companies that represent a cross-section of industry in a given country. For instance, they may own shares of the largest 50 publicly traded stocks in a specific country as measured by market capitalization. You can also buy regional ETFs as well, which focus on entire continents.
  6. Leveraged ETFs. These funds use borrowed money to “gear up” their portfolios, magnifying returns. They also magnify risks as well. For instance, a leveraged S&P 500 ETF will seek to roughly double the returns of the index, minus interest and expenses. But they will also double the size of losses as well. You can also buy leveraged inverse ETFs – these are very risky.
  7. Currency ETFs. These securities seek to capture the returns of foreign currencies.
  8. Bond ETFs. These are just like stock ETFs, except they own bonds instead of stocks.

Uses of ETFs

ETFs can be useful to investors who want very focused exposure to a specific industry, region, currency, or asset class at a reasonable cost, without having to worry about researching specific securities. Because their costs are so low, they are also useful as long-term core holdings for buy and hold investors.

For those who use an asset allocation approach to investing, it’s possible to find ETFs that focus on asset classes that have a very low correlation coefficient with the rest of your portfolio. This means that when your portfolio “zigs,” the ETF you are looking for tends to “zag.” The result is, ideally, less overall volatility for your portfolio as a whole.

ETFs are excellent vehicles for getting exposure into gold and precious metals-related securities, specific countries or regions, or specific industries.

Suitability

ETFs are best suited for investors who intend to hold them for a long time. This gives the lower long-term expense ratios of these securities (compared to competing actively managed mutual funds and even open-end index funds) time to build up. They are also very useful as trading vehicles, especially if you don’t want to drill-down too deeply in any one company, or retain too much individual company risk.

The most important consideration, from a suitability point of view, is the underlying index and how it fits in with your overall portfolio and strategy.

Final Word

These are just a few of the many uses of ETFs in portfolios. For further details about how to go about investing in an ETF, and whether it makes sense for your situation, speak to a trusted financial advisor, or do your own due diligence on the fund or funds in which you’re interested.

Do you invest in ETFs? Why or why not?

(photo credit: Shutterstock)

Jason Van Steenwyk
Jason Van Steenwyk has been writing professionally about finance, insurance, economics, and investing since 2000. He got his start in journalism with Mutual Funds magazine. Since then, he has published feature articles for financial professionals and consumers alike in Registered Rep., Wealth & Retirement Planner, Senior Market Advisor, The Annuity Selling Guide, The Honolulu Advertiser, and many more. He is also a former insurance agent, where he worked with individuals and small business owners on planning their life insurance, health insurance, long term care and retirement needs. An avid musician, Jason is also a semiprofessional guitarist and fiddler, and proud member of the Army National Guard for 20 years. He lives in Fort Lauderdale, Florida.

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  • http://youhavemorethanyouthink.org/ Shawanda

    For the most part, I like ETFs. Especially when I can buy and sell them without paying trading fees. But I’ve never seen a lot of value in the ability to sell ETF shares during the day as opposed to at the end of the day (as is the case with mutual funds). It’s probably because I don’t change my investment strategy based on daily movements in the stock market, but I don’t understand what’s so terrible about waiting a few hours to sell my mutual fund shares.

    • http://www.facebook.com/people/Jason-Van-Steenwyk/1067420567 Jason Van Steenwyk

      Hello, and thanks so much for commenting, Shawanda! Sure, if you’re not a trader, then there’s little advantage – in normal times – to being able to buy and sell shares “intra-day.” If there are big changes in the market, though, the ETF trader has a huge advantage over the mutual fund owner. If there were a sudden nuke strike on the Korean peninsula at 10 am ET, and Asian markets began to plummet because investors were adding a huge risk premium, for example, the fast hands could dump Korean or Asian emerging market ETF shares by noon. In a mutual fund, you’re stuck until the end of the day. And you won’t know if your fund manager is taking any action to preserve shareholder value in the meantime. This was a big factor when markets plummeted amidst the TARP debate in 2008, and during the crash of October 1987. Similarly, you can buy into the market on good news, too, way ahead of the traditional mutual fund investor. Say the Fed issues a statement saying it expects growth rates substantially ahead of expectations, sending the Dow up 500 points in one day. A big part of that 500 points will come within an hour or two of the announcement. ETF traders can exploit that movement; open-end fund holders will get what’s left over. Not a big deal in normal times, but it can be a big deal in a crisis, even for someone who is normally a buy-and-hold kind of investor. This is also important if you’re a profession money manager, holding assets on your clients behalf for a fee. You don’t want to have to apologize to your client for a needless loss on bad market news because you had to wait until the end of the day for your sell price to be calculated.

  • http://www.manhattancalumet.com/ Dennis The Menace

    I like exchange traded funds so very much because they can reduce your risk because when buying a exchange traded fund your buying a whole basket of stocks instead of just a single security. In theory an exchange traded fund cannot go to zero unlike individual stocks. The second advantage of exchange traded funds is that their are now thousands of funds to choose from. I particularly like narrowly focused funds that specialize in coal steel solar stocks among others and single country funds which buy securities in a single country like china india among many others. Because of the wide aray of funds available Today you can build a diversified portfolio of funds’ Concentrating on the exchange traded funds that are most out of favor and have declined by the largest percentage. For example their is a solar Exchange traded fund that trades around 3.00 dollar a share it was trading at 30.00 dollars a share about five years ago. Their are also some single country exchange traded funds that are down by 80% from their highs. The only word of caution for anyone considering investing in exchange traded funds is this always avoid exchange traded funds that use leverage to magnify their returns. These exchange traded funds usually are marketed under double or trible the return of standard and poors five hundred index or some other index. So be very careful of these exchange traded funds because their a very dangerous place to be putting your money their more like options or futures than exchange traded funds in my opinion.

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