What is ETF ?

Exchange Traded Funds

ETFs have several similarities to mutual funds. Like a Mutual Fund, an ETF is a pool or basket of investments. However, ETF’s many times have lower expenses then a similar mutual fund in that there are no loads and the operating expenses are often lower. FINRA posted the following comparison of expenses on its website.

Fund Type           Average Total TOT -0.39% Operating Expenses

Mutual Funds    ETFs

US Large-Cap Stock         1.31%    0.47%

US Mid-Cap Stock            1.45%    0.56%

US Small-Cap Stock         1.53%    0.52%

International Stock         1.57%    0.56%

Taxable Bond    1.07%    0.30%

Municipal Bond                1.06%    0.23%

Another primary difference is that an ETF doesn’t trade
at the end of the day like a Mutual Fund. The price of the ETF is determined by investor demand at any given time during the trading day.

How to Buy ETF’s

ETF’s are bought and sold like stocks. There is the bid price from buyers and the ask price from sellers.  So when you go to buy an ETF you do not place an order for $10,000. If you want to invest that amount you need to determine the number of shares to buy.

To start, look at the bid and ask price and figure that what you will pay will be somewhat close to those numbers. Lets say that the bid for an ETF that you are interested in is $45.15 and the ask is $45.18. Divide $10,000 buy the ask price $45.18 and you get 221.34 shares. You would place an order for 221 shares. A short time later your order will be filled and you will learn the exact price that was paid. Let’s say that the order was filled at $45.17. You will pay $9,982.57 for the shares and there will be a transaction fee from your custodian to place the order. Let’s say it was $9 for the trade. Therefore you paid a total of $9,991.57 for your 221 shares of the ETF.

The “spread” which is the difference between the highest acceptable buy price and the lowest acceptable sell price can vary based on the volume of selling and the demand for the shares. While the bid-ask spread might be only 1 penny in the case of widely traded ETF’s it might also have a much wider spread for a less liquid ETF. If you are going to buy a large order of a lightly traded ETF, you would be well served to buy in several smaller orders to avoid a big increase in the spread. Talk to your advisor or custodian about this if you are unfamiliar with this topic.

ETF Tax Efficiency

ETF’s are more tax effective than mutual funds. An ETF’s ability to decrease or avoid capital gain distributions comes from two differences: Unlike mutual-funds where shares are redeemed with the Fund directly, ETF’s are traded on an exchange just like a stock. When one party sells the ETF and another buys on the exchange so the underlying securities within the ETF are not sold to raise cash for the redemption, therefore no gain- no tax. The redemption process also enables the fund manager to sell the most effective cost-basis stocks through stock transfers during the redemption or creation process. These characteristics can also mean a difference in the after-tax rate of returns from a mutual fund versus an ETF, even when they both replicate the same underlying index.

For example, a tech mutual fund may claim Apple as one of its top holdings, but a rally in Apple shares may barely move the mutual fund, on account of Apple only comprising 2% of the overall portfolio, and the remaining 98% being comprised of industry laggards such as Cisco. In this same example, however, a crash in Apple shares will also be cushioned by its low portfolio weight and buffered by other less volatile stocks. Although the growth of mutual funds may be limited, the downside is limited as well.