The Power of the ETF - Changing the Way the World Invests
Rizek Housari, CPA, CFP®
AUTHORS NOTE
Creating a custom financial model of your future gives you the framework and lens to make important financial decisions.
How to best mitigate and manage your tax burden is just one of the important decisions to consider.
At Divergent Wealth we are state-of-the-art financial planners and investment professionals who specialize in simplifying complicated things.
To create a complimentary customized financial plan, call us at 385-CFP-4000. For information, visit us at www.divergentwealth.com.
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Exchange Traded Funds, also known as ETFs, have changed the way the world invests. ETFs have drawn an enormous amount of capital in the last decade and there seems to be an ETF for everything these days. This article highlights critical information that you need to know about ETFs and the opportunities they give investors.
The Basket
An ETF is an investment vehicle that follows a specific sector, index, commodity, or other asset class. This is accomplished by grouping together stocks or bonds into a single fund to be purchased by investors. This is often referred to as a “basket” where a variety of investments are held together.
For example, you may purchase ETFs that track technology or foreign companies exclusively.
Bond ETFs may include corporate bonds or debt issued by a government. There are even ETFs that attempt to make money by shorting, or betting against, a specific market or sector. These are called Inverse ETFs.
ETFs provide a fundamental aspect of a solid investment strategy - diversification. Instead of purchasing dozens or even hundreds of different stocks or bonds to put in your portfolio, you can purchase a few ETFs to do that on your behalf. This makes life much easier for investors because they can get immediate diversification.
If you have ever invested in an index fund, the same diversification and low expense ratios apply to many ETFs. In fact, numerous ETFs are passive investments that track an index. Oftentimes, index funds have a matching ETF that is similar or even the exact same in composition as the index fund. Many investors choose to hold ETFs that track a market index, such as the Standard & Poor’s 500 index (S&P 500).
Costs
Passive investing can be an excellent way to cut costs and maximize your returns. Actively managed funds typically charge much higher fees in the form of commissions, fees, loads, and a myriad of other charges. While there are several different costs that funds may charge investors, typically the managing costs of passive index funds and passive ETFs are lower than actively managed funds. One way to compare fees between funds is through a metric called the expense ratio. The fewer fees and expenses you pay for a fund in your portfolio, the more money you keep working for you.
Consistency Over the Long Run
Strong evidence supports the fact that the majority of actively managed funds do not beat their benchmark from year to year, meaning that they ultimately underperform. A common benchmark for the stock market is the S&P 500. For this reason, many investors choose passive funds that track an index. “Beating the market” is attempting to outperform a benchmark. This can be extremely tempting and repeatedly touted by those who like to time the market or the next hot company. As appealing as this may be, prudent investors would be wise to look at the chronicles of history as a guide for navigating their own wealth. It is incredibly difficult and costly to try to “beat the market.”
So what else makes ETFs different than a mutual fund, or specifically an index fund? Here are a few key differences to consider.
Minimums to Purchase
Lower minimums allow investors to begin purchasing ETFs without having to meet a specific amount of invested capital, as many mutual funds require.
Transacting and Pricing
Both ETFs and mutual funds are valued based on their Net Asset Value (NAV). Funds do this by taking the total amount of cash and securities divided by the number of outstanding shares. The difference is that ETFs trade on an exchange such as the New York Stock Exchange or the Nasdaq throughout the day, hence “exchange traded”. This means that ETFs have real-time pricing that moves throughout the day. EFTs also tend to be more liquid which can cause premiums or discounts to arise in the price of an ETF. On the other hand, a mutual fund trades once at the end of the day after the markets close, and the price of the mutual fund is derived from the NAV of the securities the fund holds.
Tax Implications of Funds
Taxes also differentiate mutual funds from ETFs. This typically impacts taxable accounts more than retirement accounts as traditional retirement accounts postpone the recognition of income. While both mutual funds and ETFs are subject to taxation of dividends and capital gains, the general structure of ETFs tend to minimize taxes for the average investor.
Mutual fund managers must sell and/or re-balance their holdings from time to time. This happens when investors redeem their shares or when they have too much of a certain asset within the fund. The IRS gets their piece of the action when capital gains are realized (that’s tax lingo for “sold”). These gains are passed through to shareholders, some of whom may be in the red, or have unrealized losses in their mutual fund investment. This income event results in them having to pay taxes on the gain distributed or assigned to them. That can be tough to swallow for mutual fund investors who first become aware of this fact.
Interestingly, ETFs have a different underlying structure than mutual funds. ETFs can make what are referred to as “creation units”, which approximate the ETF’s market exposure. It is these creation units that allow managers to oblige the inflow and outflow of capital. The ETF manager can take advantage of this ability to generate and redeem these creation units so that investors frequently are not burdened by capital gains on any one security held in the fund.
However, capital loss carryovers can be used by mutual fund managers to harvest losses from previous years to offset gains in future years, so it is not totally David v. Goliath here. Additionally, there are a few other tax mitigation tactics that can be used by mutual funds to offset the tax impact on their investors.
Taxation of International ETFs
Some international ETFs can be less tax efficient, especially those with increased exposure to emerging markets. This is because the in-kind delivery of securities inside these ETFs is restricted. As a result, selling securities may be required to generate cash for redemptions as opposed to delivering stock. The IRS again takes its cut when the gains on these securities are realized.
A Tax Warning to the Leveraged and Inverse ETF Holders
Not all ETFs are created equal, especially in the eyes of the IRS. Leveraged/inverse ETFs regularly contain derivatives that are taxed in a particular way. Gains from derivatives are taxed 60/40, meaning 60% of the gain is taxed at long-term rates and the other 40% at short-term rates. You may recall that long-term gains are often preferred, whereas short-term gains are taxed at your marginal ordinary-income rate. Moreover, these types of ETFs can be extremely volatile, and their expense ratios are usually much higher as well.
The Opportunity
There are so many opportunities to consider when incorporating ETFs into your portfolio. Take time to consider what role ETFs should play in your portfolio. Reducing risk and preserving wealth is critical to a sound portfolio’s long-term performance. Wise investors maintain a diverse portfolio of funds and asset classes. There are numerous ETFs with different objectives, so it is imperative that you know what you are investing in when you purchase an investment.
CONCLUSION
Creating a custom financial model of your future gives you the framework and lens to make important financial decisions. Tax Planning is just one of the important decisions. At DivergentWealth®we are state-of-the-art financial planners and investment professionals who specialize in simplifying complicated things. To create a customized complimentary financial plan, call us at 385-CFP-4000. For information, visit us at www.divergentwealth.com.
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