ETF & Features of ETFs

An exchange-traded fund (ETF) is an investment vehicle that is traded on stock exchanges, much like stocks. An ETF holds assets like stocks or bonds and trades at approximately the same price as the NAV i.e. net asset value of its underlying assets over course of the trading day. The majority of ETFs track an index, such as S&P 500. ETFs may be attractive as investment options because of their low costs, tax efficiency, and their stock-like features.

Features of ETFs

Following are the features of Exchange traded funds -

Buying and Selling ETFs Can Be Good for the Small Investor

ETFs enjoy continuous pricing; and can be bought and sold on a stock exchange throughout the trading day. Since ETFs trade like stocks, one can place orders like with individual stocks - like limit orders, stop loss orders, good-until-canceled orders, etc. They can be sold short as well. 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 that resemble the underlying NAV but at the same time are independent of it. However, arbitrageurs make sure that ETF prices are kept very close to NAV of the underlying securities.

Even though an investor can buy as few as only one share of an ETF, most buy in board lots. Anything bought in less than a board lot would increase the cost to the investor. Anyone can buy ETF no matter where in the world it is trading. This provides a benefit over mutual funds that generally can only be bought in the country in which they are registered.

Treatment of Dividends

An ETF typically pays out the dividends received from the underlying stocks on a quarterly basis. The underlying stocks pay dividends throughout the quarter. Hence, these funds can hold cash for many different time periods throughout the quarter, even though the underlying index is not composed of cash. With dividend-paying ETFs, the cash ends up in brokerage account instead, just like the dividend on a regular stock. For reinvesting that cash, one has to make another purchase.

Tax Efficiency

As index ETFs are passively managed portfolios, they tend to present greater tax benefits than regular mutual funds. These generate fewer capital gains due to the low turnover of securities, and realize fewer capital gains as compared to actively managed funds. An index ETF only sells securities to reflect the changes in its underlying index. Regular mutual funds accumulate these unrealized capital gains liabilities as the portfolio's stocks appreciate in value. When the fund sells those stocks, it distributes capital gains to the investors in proportion to their ownership. This results in greater taxes for mutual fund owners.

Transparency

ETFs are designed to replicate the performance of the underlying index or commodity. Investors know exactly what they are buying and can see exactly what constitutes the ETF. Even the fees are clearly laid out. As mutual funds only have to report their holdings twice a year, there is not much clarity about the returns.

Fees and Commissions

One of the key features of ETFs is their low annual fees, especially when compared to the traditional mutual funds. The passive nature of index investing, the reduced marketing, distribution and accounting expenses all contribute to lower fees for ETFs. However, individual investors need to pay a brokerage commission to purchase and sell ETF shares; for those investors who trade frequently, this can considerably increase the cost of investing in ETFs.

Options

A number of ETFs offer options that can be traded. They can be used for creating different investment strategies in conjunction with underlying ETF. This allows ETF investors to make use of the leverage in their portfolios.