As a financial advisor, it is important to be well-versed in the benefits and drawbacks of many different asset classes. While they maintain many of the same attributes as their mutual fund predecessors, there are five things about exchange-traded funds (ETFs) that you should be aware of to ensure you give your clients the very best guidance.

The Cheaper Option

When it comes to minimizing expenses, ETFs are often a much cheaper option than traditional mutual funds. This is due to their unique structure and to the passive nature of most ETFs.

Because ETFs can be bought and sold on the open market like stocks, individual shareholders can simply sell their shares to a new investor rather than redeeming them with the fund itself. Large-scale investors are also given the option to redeem shares in-kind. Instead of receiving cash, institutional investors can trade shares of an ETF for a basket of individual shares of stock equal to the holdings of its portfolio. This means ETFs are less likely than mutual funds to have to liquidate assets to cover shareholder redemptions.

In addition, ETFs are traditionally indexed funds that are designed to mimic the holdings and returns of a given index. Because indexed ETFs only buy and sell stocks when the underlying index adds or removes them from the roster, the number of trades these funds make each year is minimal. Fewer trades means lower fees because of the decreased workload for the fund's manager.

Not All ETFs Are Created Equal

Even though many ETFs track the same index, not all ETFs are created equal. If your client is looking for an inexpensive investment that tracks an index, an ETF is an excellent choice. Do a little research, however, and you may find a wide variation in expense ratios among funds that essentially do the same thing.

Though you should always consider the asset weighting of various funds when providing recommendations, paying a high expense ratio just to invest in a popular name-brand ETF may not be in your client's best interest. Indexed ETFs are exposed to the full risk of the market, in both bull and bear, and a high expense ratio can seriously undermine returns over the long term. If there are two ETFs that track the same index and have similar weighting strategies and historical returns, the cheaper fund is likely to be your client's best option.

Not Just for Passive Investors Any More

Though ETFs have traditionally been indexed funds, their increasing popularity has prompted the creation of many different products. ETFs are no longer the play-it-safe investment choice. Depending on the needs of your client, you can find narrowly focused sector-specific ETFs, leveraged ETFs that use borrowed money to accelerate returns and arbitrage funds that use market inefficiencies to generate tiny profits thousands of times a year.

Research the costs and risks associated with these products before making a recommendation. Some of the riskier ETFs, such as leveraged and inverse ETFs, are not really suitable for the average investor. In addition, the aggressive trading strategy of actively managed ETFs can lead to much higher expense ratios. If your client is an experienced investor who is comfortable with taking on a large amount of risk, the world of ETFs is your playground.

Built for Short- and Long-Term Investing

Unlike mutual funds, ETFs are a great investment for both long- and short-term investors. ETFs can be traded on the open market and they do not carry the load, redemption or sales fees associated with most mutual funds, so they are much simpler and cheaper to trade frequently. While ETF trades are subject to brokerage commissions, many trading platforms have introduced commission-free ETF trading programs.

If your client wants a diversified investment that can be traded in the short term to generate quick gains, ETFs are a much more suitable choice than mutual funds.

Tax Benefits

Because ETFs tend to have lower turnover ratios than comparable mutual funds as a result of their market-based trading and in-kind redemption features, they also tend to be more tax-efficient. When a fund liquidates assets to cover a shareholder redemption, it can trigger a capital gains distribution to all shareholders, thereby increasing their taxable incomes. This is why short-term mutual fund investments are discouraged; frequent shareholder redemptions negatively impact the returns and tax liability of the remaining shareholders.

Indexed ETFs are highly tax-efficient because they make very few trades each year. If your client is looking to invest in a product that is likely to generate moderate returns over the long-term without increasing her tax liability prior to redemption, indexed ETFs are an excellent choice.

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