For the first several decades of the 20th century, the investment markets were primarily accessible only to wealthy individual speculators. Then, mutual funds appeared in the early '70s and allowed lower- and middle-class investors to access professional money management. These vehicles became extremely popular with both individual and institutional investors because of their liquidity, diversity and the superior returns that many of them posted over time. But the next generation of mutual funds, known as exchange traded funds (ETFs), has arrived. This new breed of fund has several advantages over traditional mutual funds.

Basic Characteristics
ETFs resemble traditional mutual funds in that they offer diversification and professional management. They are packaged in five different ways: equity and fixed-income ETFs that can be offered as grantor trusts, unit investment trusts (UITs), open-end funds, and exchange traded notes (ETNs). ETFs that invest in commodities or currencies are usually treated as limited partnerships (LPs).

ETFs are more liquid than their traditional cousins, however, in that all types trade like stocks on an exchange during market hours, and their prices fluctuate like those of stocks or other individual securities during intraday trading. There is no daily forward pricing with ETFs. Therefore, this type of fund has become much more popular with active investors and those who move money between the various sectors of the market on a regular basis.

Tax Treatment of ETFs
Another substantial advantage of ETFs is their relatively streamlined tax treatment. ETFs typically post fewer and lower capital gains distributions than traditional mutual funds. One of the main reasons for this tax treatment is that there is usually a much lower rate of portfolio turnover in ETFs. Many of these instruments mimic an index, such as the S&P 500, and therefore are not actively managed.

Another reason for ETFs' streamlined tax treatment is the difference in how ETFs and open-end funds issue and redeem their shares. Small investors who wish to trade shares of an ETF will buy and sell them on an exchange in the secondary market just like any other publicly traded security. But ETFs are created when a large investor, known as an authorized participant, delivers a package of securities to the ETF issuer that is used to constitute the fund portfolio. Authorized participants are then issued 100,000-share blocks of the fund that are known as creation units. This transaction is classified as an in-kind exchange and is therefore not taxable.

Portfolio managers of traditional mutual funds are instead forced to buy and sell securities in order to match the demand for fund shares, which in turn creates taxable gains and losses. Of course, the losses that they incur are used to offset the gains to some degree, but the overall amount of capital gains that are distributed to shareholders in open-end funds is higher on average than for ETFs. And because many ETFs are clones of a financial index, they will generate little or no taxable investment income such as dividends or interest, and the investor will only realize a capital gain or loss upon their sale.

ETFs are also excellent vehicles for investors who own securities that have declined substantially in value. An investor who owns a technology stock that hit the skids might be wise to dump the shares and use the proceeds to purchase an ETF that invests in a portfolio of similar holdings. These transactions will effectively circumvent the wash sale rule and allow the investor to realize an immediate loss on the sale because stocks and ETFs are not considered to be like-kind securities.

The Bottom Line
ETFs are growing rapidly in popularity with both novice and sophisticated investors due to their liquidity, versatility and superior tax treatment. For more information on ETFs, consult your financial advisor or stockbroker.

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