The vast majority of ETFs are designed to track an index, so their performance is close to that of an index mutual fund, but they are not exact duplicates. A tracking error, or the difference between the returns of a fund and the returns of the index, can arise due to differences in composition, management fees, expenses, and handling of dividends. Let's take a look at some of these factors.
Buying and Selling ETFs Can Be Good for the Small Investor
ETFs enjoy continuous pricing; they can be bought and sold on a stock exchange throughout the trading day. Because ETFs trade like stocks, you can place orders just like with individual stocks - such as limit orders, good-until-canceled orders, stop loss orders etc. They can also be sold short. Traditional mutual funds are bought and redeemed based on their net asset values (NAV) at the end of the day. ETFs are bought and sold at the market prices on the exchanges, which resemble the underlying NAV but are independent of it. However, arbitrageurs will ensure that ETF prices are kept very close to the NAV of the underlying securities.
Although an investor can buy as few as one share of an ETF, most buy in board lots. Anything bought in less than a board lot will increase the cost to the investor. Anyone can buy any ETF no matter where in the world it trades. This provides a benefit over mutual funds, which generally can only be bought in the country in which they are registered.
Treatment of Dividends
An ETF typically pays out dividends received from the underlying stocks on a quarterly basis. However, the underlying stocks pay dividends throughout the quarter. Therefore, these funds can hold cash for various time periods throughout the quarter, even though the underlying benchmark index is not composed of cash. With dividend-paying ETFs, the cash ends up in your brokerage account instead, just like the dividend on a regular stock. If you want to reinvest that cash, you have to make another purchase.
Because index ETFs are passively managed portfolios, they tend to offer greater tax benefits than regular mutual funds. They generate fewer capital gains due to low turnover of the securities, and realize fewer capital gains than actively managed funds. An index ETFs only sells securities to reflect changes in its underlying index. Traditional mutual funds accumulate these unrealized capital gains liabilities as the portfolio's stocks increase in value. When the fund sells those stocks, it distributes the capital gains to its investors in proportion to their ownership. This selling results in greater taxes for mutual fund owners. (For related reading, see How To Use ETFs In Your Portfolio.)
As mentioned, ETFs are designed to replicate the performance of their underlying index or commodity. Investors always know exactly what they are buying and can see exactly what constitutes the ETF. The fees are also clearly laid out. Because mutual funds only have to report their holdings twice a year, when you buy into a mutual fund, what you're getting may not be as clear.
Fees and Commission
One of the main features of ETFs are their low annual fees, especially when compared to traditional mutual funds. The passive nature of index investing, reduced marketing, and distribution and accounting expenses all contribute to the lower fees. However, individual investors must pay a brokerage commission to purchase and sell ETF shares; for those investors who trade frequently, this can significantly increase the cost of investing in ETFs. That said, with the advent of low-cost brokerage fees, small or frequent purchases of ETFs are becoming more cost efficient. (For more insight, read 3 Steps To A Profitable ETF Portfolio.)
A number of ETFs have options that can be traded. They can be used to create different investment strategies in conjunction with the underlying ETF. This allows ETF investors to make use of leverage in their portfolios. (For more insight, read Dissecting Leveraged ETF Returns.)
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