Guide to ETF Trading
Exchange-traded funds or ETFs are an increasingly popular investment option. Like mutual funds, ETFs are portfolios of investments such as stocks or bonds. Unlike stocks or bonds, ETFs are not a separate asset class but are rather a means to access different asset classes in a diversified manner. While ETFs have a lot in common with mutual funds, they have several advantages. ETFs are traded intraday over an exchange like a stock, whereas mutual funds are traded once a day directly with the fund provider. ETFs have the potential to be more tax efficient than a comparable mutual fund due to the in-kind redemption mechanism. Finally, ETFs tend to be lower cost than mutual funds and there are some great dividend ETFs out there for your consideration.
The mutual fund structure is more 80 years old, whereas ETFs are only about 20 years old. ETFs are organized under the same laws that govern mutual funds, except that they trade on an exchange, create and redeem shares only through authorized participants and only in large blocks. In other words, the average investor cannot redeem his shares of an ETF for the underlying holdings and cannot go to the ETF provider to redeem his shares. While ETFs represent a technological improvement over mutual funds, smooth trading of ETFs depends on smoothing functioning markets. When trading becomes difficult, such as during periods of heightened volatility, the bid-ask spread on ETFs can widen out. Therefore, it is best to use limit orders when trading ETFs. You may also want to looking at Forex trading.
Closed-end funds also trade on exchange and often trade with large premiums and discounts. Those premiums and discounts can persist because it is difficult to create or redeem shares of a closed-end fund. In contrast, shares of an ETF can always be created or destroyed. Thus, premiums and discounts on ETFs are typically small as traders are constantly monitoring ETFs, looking to exploit any premium or discount. More information on closed-ends funds will be included in another article.
When investing in mutual funds, investors face taxes on two levels: when they sell their mutual fund at a gain or when the mutual fund itself sells stocks for a gain it is forced to issue a capital gain distribution. ETF investors still face both kinds of taxes. However, ETFs are often able to reduce the incidence of incurring capital gains. Whenever mutual fund investors redeem shares, the fund typically must sell stocks to raise cash to fund the redemptions. ETFs are able to fund these redemptions without directly selling stocks. Rather they swap shares of the ETF with the authorized participant. Many ETFs have never issued a capital gain.
A typical mutual fund charges around 1% per year, whereas the lowest-cost ETFs charge as little as 0.20%. In an environment where future returns may be lower, having a lower expense ratio is a big advantage. Some of the lowest-cost ETFs charge just 0.05%. For example, Vanguard Total Stock Market ETF symbol VTI charges 0.05% while Schwab US Broad Market ETF SCHB charges just 0.03%. It is difficult for active managers to overcome that expense ratio disadvantage every year. Most ETFs are index funds, but that does not mean that they are all passive. Many indexes take an active approach to portfolio construction, either by using filters to select securities or a different weighting mechanism which impacts the risk/return profile and the rebalance process.
We will be going over investment fees more in depth in a subsequent article.