Exchange traded funds, or ETFs, are pooled investments that combine aspects of mutual funds with those of individual stocks. Like a mutual fund, each ETF owns a group of investments, sometimes described as a basket, which reflects the composition of the index that the ETF tracks. But like a stock, an ETF is listed on an exchange and trades throughout the day, so that an order you place to buy or sell is executed at the current trading price.
You buy ETFs for the same reason you buy mutual funds—to achieve a level of diversification in an asset subclass that‘s difficult to accomplish on your own with a portfolio of individual securities. In addition, because there are so many ETFs tracking both broad and narrow segments of the market, you can use ETFs, or a combination of ETFs and individual securities and mutual funds to add asset classes to your portfolio that you might not be able to invest in otherwise. But ETFs, despite the word “fund” in their names, are not—and are not allowed to call themselves—mutual funds.
Net asset value (NAV) is calculated in the same way a mutual fund’s is, by dividing the combined value of the basket of securities the ETF holds by the number of shares that have been created. The market price is not identical to the NAV, as is the case with open-end mutual funds because it is affected by investor demand—or lack of it—for shares. But unlike closed-end funds, which they resemble in certain ways, ETFs are constructed so that the trading price rarely moves much above or below the NAV. This means there’s little risk of having to pay a premium or sell at a discount.
Like other investments, your ETF may increase in value, and, if you wish you can sell at a profit. Of course, if the NAV falls and you sell, you may have a loss. You also benefit if the securities an ETF holds pay interest or dividends. That income may either be reinvested or paid to shareholders quarterly or annually, depending on the way the ETF is structured.
You can own ETFs in taxable, tax-deferred, or tax-free accounts. In taxable accounts, any capital gains the fund realizes from selling shares are taxed in the year you realize them, though the rate that applies may be your long-term capital gains rate. However, ETFs that track traditional indexes tend to have fairly modest turnover and so are fairly tax efficient.
In contrast, in a tax-deferred account, gains become part of the total assets in the account and are taxed at your ordinary rate when you withdraw at some point in the future. In a tax-free account, any gains or income escape tax if you follow the rules for withdrawal.
You buy ETFs through your brokerage account, as you do individual stocks, and pay a commission on each transaction. In addition, ETFs have expense ratios, as mutual funds do, calculated as a percentage of the assets you have invested. However, ETF expense ratios tend to be closer to the fees on index funds than to those on actively traded funds—and in many cases are lower than comparable index funds.
Unlike mutual funds, it is also possible to buy ETFs on margin and sell them short. These advanced investment strategies may be useful for some experienced investors.
Because of the commission you pay on each transaction, ETFs, like individual stocks, are generally not recommended for incremental investing strategies such as dollar cost averaging because the sales charges could erode investment return. However, the same caution applies to load mutual funds.
When you’re considering an index investment, you’ll want to think about some of the ways in which ETFs and mutual funds differ.
ETFs don’t need to hold much of their portfolio in cash as mutual funds do, because they don’t have to buy back shares that investors want to redeem. Instead shares are bought and sold among investors at the market price. Cash assets rarely provide the same level of return as assets fully invested in securities. For the same reason, ETFs don’t have to sell investments to raise cash when investors are selling shares. This reduces transaction costs and short-term capital gains, both of which can reduce your overall return on a mutual fund.
On the other hand, ETFs that track smaller or nontraditional indexes may be thinly traded, which could make it difficult for you to sell at a price you want. In addition, if the compositions of nontraditional indexes change frequently, as is sometimes the case, the ETF will be less tax efficient than you might have anticipated.