Getting Started With ETFs

February 24, 2022

Advantages of ETFs

The ETF structure has a number of advantages relative to other investment vehicles that make them attractive to individual investors, financial advisors and institutions alike. These advantages include the following.

Asset Class Coverage
ETFs cover a wide range of asset classes, and offer access to just about any asset, theme and/or strategy. ETFs can invest in all sorts of securities, including stocks, bonds, commodities (physical or futures contracts), derivatives, alternatives and currencies. They can offer access to sectors, industry segments, countries, themes, outcomes and the like.

The go-anywhere nature of ETFs allows for the construction of well-diversified portfolios that may be laser-focused on a given part of the market or offer broad exposure to major asset classes.

Trading Flexibility
ETFs can be bought and sold throughout the day when markets are open. ETFs can also be sold short; they can be purchased on margin; and they allow for the use of limit orders and stop orders. The ability to place stop-loss and sell stop-limit orders on ETFs is an often-overlooked feature that can be beneficial to investors.

A stop-loss order is simply an order placed with a broker to sell a security when it crosses below a specific price threshold. For example, if an ETF share is purchased for $25.00 and a 10% stop-loss order is immediately placed on the share, the broker will execute the sale of the share at the market price when the ETF trades at $22.50 or lower. Note that a stop-loss order doesn’t guarantee the trade will be executed at $22.50, only that the sell order will be triggered at that level. If the price of the security is deteriorating rapidly, the sale could actually be executed at a lower price.

A sell stop-limit order is similar, except that more precise control can be exercised over the sale price. If a stop is entered at $22.50 with a limit of $22.00, the sale will be triggered once the ETF trades at $22.50 or lower, but the trade will only be executed if the broker can sell at a price of $22.00 or better. This allows the investor to ensure they receive a specific price or better for the ETF if the sale order is triggered. It’s important to note that if the price of the ETF quickly fell below $22.00 before the sale could be executed, then the sell order would not be filled (versus a stop-loss order, where the order would be filled regardless of the price once the ETF hit $22.50 or lower).

ETF investors can use stop-loss and sell stop-limit orders to ensure they lock in profits and limit severe drawdowns in the event of a sharp market decline. That’s a unique advantage of ETFs. By contrast, mutual fund sales can only be executed based on the net asset value of the shares of the fund once a day, at market closure.

Low Costs
ETFs typically have much lower expense ratios than actively managed mutual funds, and are usually comparable to or less expensive than index mutual funds. These lower costs are generally a result of lower internal fund operating costs and a lack of load or redemption fees. Because of their structure, ETFs are generally insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions, as is the case in mutual funds. When investors transact in their ETFs, they typically do so directly with other investors in their brokerage accounts, unlike mutual fund investors, who have to transact through the mutual fund company, which incurs several processing costs along the way.

Since ETFs are typically passively managed products, they also don’t include the costs of paying for expensive fund managers. Even in the case of actively managed ETFs—those that don’t track an index but instead have a fund manager making portfolio decisions—these funds are typically more cost-competitive than active mutual funds for the reasons listed above. ETFs tend to have much cheaper costs related to customer service departments, sales distribution, and other infrastructure associated with supporting and marketing large actively managed mutual funds. ETFs do not charge 12b-1 fees like their mutual fund counterparts. All of these cost efficiencies of the ETF wrapper translate into cost savings for ETF investors relative to similar mutual fund structures.

Tax Efficiency
ETFs are not tax-free, but are tax efficient relative to traditional mutual funds. Behind that efficiency is the hallmark of the ETF structure: the creation/redemption mechanism. This mechanism of creating and redeeming ETF shares, keeping the share supply elastic to meet supply and demand, generally does not trigger a capital gains event because the IRS treats exchanges of index components for shares of ETFs as nontaxable, in-kind exchanges.

Consequently, ETFs can routinely expunge low-cost-basis holdings in the course of routine redemption activity. This results in ETFs typically carrying relatively high-cost-basis shares. When an index is reconstituted or rebalanced and, thereby causes the ETF to buy and/or sell corresponding holdings in order to track that index, the prior expunging of low-cost-basis holdings helps to minimize the risk of realizing capital gains. This process ultimately means you typically don’t have the taxable capital gains distribution exposure that you have with traditional mutual funds.

Most ETFs are required to report their underlying holdings on a daily basis so investors always know exactly what they own. Portfolio transparency has been a hallmark of the ETF structure, and one that stands in contrast to mutual funds, which are only required to report their holdings on a quarterly basis, and often 30 days in arrears at that.

This transparency is linked to the ETF creation/redemption process itself, where ETF issuers disclose daily what securities are in a given ETF portfolio so that an authorized participant or market maker knows what holdings they need to create shares of that ETF. Transparency is also a byproduct of the predominantly passive nature of ETFs, as index providers disclose index composition on a regular basis.

That said, in 2020, a new genre of ETFs came to market introducing portfolio opacity as a feature. Known as semi- or nontransparent ETFs, these new actively managed funds do not disclose portfolio holdings on a daily basis, but vary disclosure periods depending on the ETF model used.

Nontransparent active ETFs are still a novel minority of funds in the market today. The vast majority of the more than 2,800 U.S.-listed ETFs are fully transparent vehicles.

One of the great attributes of ETFs is portfolio diversification. ETFs trade as single stocks under a single ticker, but they are baskets of multiple securities. For example, the Vanguard Total Stock Market ETF (VTI) trades all day like a single stock, but its portfolio comprises more than 3,400 individual companies. Similarly, the iShares Core U.S. Aggregate Bond ETF (AGG) is a single fund that represents nearly 10,000 different bonds in a single portfolio. ETFs can also offer diversified mixes of assets, combining equities, bonds, alternatives and derivatives within a single portfolio.

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