Water Well Journal
Issue link: http://read.dmtmag.com/i/515025
E xchange-traded funds, known as ETFs, are an invest- ment product that was introduced less than 20 years ago, and they continue to grow at a remarkable rate. Both in- dividual and institutional investors have contributed to almost a 12-fold increase in net assets since year-end 2003. That kind of popularity deserves a close look by every investor. What is an ETF? Much like a regular mutual fund, an ETF holds a basket of assets such as stocks, commodities, or bonds. One important difference is ETFs trade on the stock ex- changes much like regular stocks. That is, they are bought and sold throughout the trading day at market prices that may be more or less than their net asset value. The value of regular mutual fund trades is not known until the end of each trading day when their net asset value is determined. Most—but not all—ETFs are index-based. In other words, they are designed to track the performance of one of the major stock indexes such as the Standard & Poor's 500 or the Dow Jones Industrial Average. Important similarities and differences ETFs are similar to mutual funds in that either can be used to build a well-diversified portfolio of stocks, bonds, and other types of assets. As with mutual funds, ETFs are usually structured as open-end investment companies. As such, both are governed by essentially the same Securities and Exchange Commission regulations. Like stocks, ETFs can be bought on margin and sold short. Among the most important differences between ETFs and mutual funds—ETFs can be bought or sold on a stock ex- change through a broker in the same way as regular stocks. Mutual funds, on the other hand, are not listed on stock exchanges. Instead, they are bought and sold through such sources as brokers, financial planners, banks, insurance agents, or directly from the issuing mutual fund companies such as Vanguard, Fidelity, and T. Rowe Price among many others. ETFs are also priced differently. While mutual fund shares can be bought or sold anytime during the trading day, all or- ders will be executed at the same price at the end of the day. ETF shares are bought, sold, and executed at the constantly changing but known market price. What are the benefits of ETFs? Because most ETFs are passively managed, they do not re- quire the use of highly paid managers. As a result, manage- ment fees are much lower than for actively managed funds. In addition to management fees, expense ratios for actively managed mutual funds are higher because of such expenses as marketing, paying a board of directors, and front-end or back-end load fees assessed at the time of buying or selling. In essence, ETFs are mutual funds that have a secondary market—they can be bought or sold at current market prices during the trading day. This feature gives investors the same liquidity provided by stocks without the need and responsibil- ity of selecting individual stocks. The vast majority of ETF investors buy and sell ETFs in the secondary market, that is, on stock exchanges such as the New York Stock Exchange. ETFs are more tax-efficient than mutual funds. Mutual funds are required to distribute capital gains to shareholders whenever the fund sells shares at a profit. Shareholders are required to pay the taxes on their share of the capital gains. When an ETF buys or sells shares, the transactions are known as in-kind transfers which do not result in a tax charge. What are the disadvantages of ETFs? Unlike open-ended mutual funds, ETFs don't allow the reinvestment of dividends—dividends are paid to owners at the end of each quarter. This effect—called "dividend drag"— can have a slightly adverse effect on overall performance. The purchase of ETFs incurs a brokerage fee just as does the purchase of stocks. For purchases in small amounts where the fee would be a significant percentage of the total invest- ment, it may be better to buy a no-load, no-transaction fee mutual fund. Also, because of the fees associated with their purchase, ETFs may not be cost-effective for dollar-cost averaging or repeated purchases over time. As is the case with stocks, selling an ETF when finances require you to do so may be difficult if the issue is thinly traded or if the market is undergoing unusual volatility. WILLIAM J. LYNOTT YOUR MONEY TAKING A CLOSER LOOK ETFs are growing at great rates, so find out if they will work for you. 36 June 2015 WWJ waterwelljournal.com Because most ETFs are passively managed, they do not require the use of highly paid managers.