What Are ETFs? Understanding These Tools and Their Uses in Our Investment Portfolios
If you have a retirement plan, brokerage account, or other type of investment vehicle, you’ve probably at least heard of a mutual fund before.
Mutual funds allow easier access to a wider array of securities and assets than most investors could access or afford without them. These funds act like baskets of stocks, bonds, or other securities traded in financial markets, and are a quick, simple way to diversify your portfolio at a lower cost.
Mutual funds have been around for a while — but ETFs are a bit newer. I’ve found that most people aren’t as familiar with these, or have never heard of them at all.
So let’s take a closer look at ETFs, because we use them in the investment portfolios we put together for clients at Lake Road Advisors.
Here’s what you should know, and where to go if you want to learn more.
What Are ETFs?
“ETF” is an acronym that stands for exchange-traded fund. ETFs usually track an underlying index, although they can invest in any number of industry sectors or use various strategies, and they’re a type of security that involves a collection of securities, like stocks or bonds.
In this way, exchange-traded funds are very similar to mutual funds: buying into one gives you access to holding hundreds or even thousands of individual assets within your portfolio.
Fundamentally, ETFs and Mutual Funds do the same thing. They provide this kind of broad, diverse exposure to multiple securities automatically (which is much easier, faster, and cheaper than you as an individual investor buying in to every single security within the fund on your own).
Are ETFs Better Than Mutual Funds for Your Investment Portfolio?
Once you understand these similarities between ETFs and mutual funds, it’s fair to ask if it really matters which you choose for your investment portfolio — or if one is better than the other.
At Lake Road Advisors, we do prefer using ETFs in our client portfolios for multiple reasons. Here are three major reasons why, explained and backed up by some of the best resources on exchange-traded funds:
ETFs Generally Cost You Less Than Mutual Funds
The cost of your investments plays a huge role in how much wealth you actually accumulate over your lifetime. The more expensive it is to invest, the more money you have to dedicate to paying things like expense ratios… and the less money you have actually working for you to earn compounding returns.
As Betterment explains, some index-tracking mutual fund administrators segment their funds into several share classes where institutional and high net-worth investors can secure lower fees and more lenient terms in exchange for investing a higher amount upfront. Retail investors with lower available investment balances are funneled into higher fee share classes with more stringent terms.
By comparison, with only one share class, ETFs are investor-type agnostic. The result is that ETF administrators provide the same exposures and low fees to the entire spectrum of potential buyers.
That’s why we really appreciate ETFs, because they generally cost less than their mutual fund cousins. This is especially true in the index tracking world of investments, which are the vehicles we use within our investment portfolios.
ETFs Provide Us with the Opportunity to Take Advantage of Intraday Liquidity
If you have mutual funds in your portfolio, you can only trade these after the close of each market day. That means if the market starts a freefall at 11am and you want to respond… well, you can’t. At least not until after the market closes for the day.
ETFs, however, are a little different. They benefit from intraday liquidity. As ETF.com explains, “those fancy words mean you can buy and sell ETFs at any time during the trading day. If the market is falling apart, you can get out at 10 am.”
That could be a big advantage, since it means you don’t have to wait until the close of trading hours — which could be a costly few hours.
ETFs Offer Far Greater Tax Efficiency
Death and taxes may be the only certainties in life, but that doesn’t mean we can’t do what is in our control to keep them both as far away from us as possible!
When it comes to taxes and your investments, tax efficiency, just like lower-cost options, means keeping more of your wealth in your portfolio (and eventually your pockets). And ETFs are vastly more tax efficient than mutual funds.
If either a mutual fund or an ETF sells a security that appreciates in value, that creates a capital gain. And as ETF.com explains, “these sales can result either from the fund selling securities for a tactical move, due to a rebalancing effort, or to meet redemptions from shareholders.”
Throughout the year, any capital gains that pile up as a result must be doled out to the fund’s shareholders… which means individual investors like you. The more in realized gains the fund has, the more taxes you will probably pay.
And mutual funds tend to push out far more capital gains to investors participating in the fund than ETFs do.
Data from ETF.com shows the average emerging markets equity mutual fund paid out 6.46 percent of net asset value in capital gains annually. By comparison, the average emerging market ETF paid out just 0.01 percent of net asset value over the same time period.
ETFs are more tax-efficient because they’re index funds. (Mutual funds can be index funds, too, but not all of them are.) Following an index means you create very little turnover, which means you also have much fewer capital gains than an actively-managed mutual fund.
But again, you can have passively-managed mutual funds with little turnover too. So why are ETFs still generally regarded as the more tax-advantaged eay to go?
It has to do with the way that the shares in exchange traded funds are created and redeemed. Let’s go back to ETF.com for a full explanation here:
“When a mutual fund investor asks for her money back, the mutual fund must sell securities to raise cash to meet that redemption. But when an individual investor wants to sell an ETF, he simply sells it to another investor like a stock. No muss, no fuss, no capital gains transaction for the ETF.
What happens when an AP redeems shares of an ETF with an issuer? Actually, it gets better. When APs redeems shares, the ETF issuer doesn’t typically rush out to sell stocks to pay the AP in cash. Rather, the issuer simply pays the AP ‘in kind’ —delivering the underlying holdings of the ETF itself. No sale means no capital gains.
The ETF issuer can even pick and choose which shares to give to the AP—meaning the issuer can hand off the shares with the lowest possible tax basis. This leaves the ETF issuer with only shares purchased at or even above the current market price, thus reducing the fund’s tax burden and ultimately resulting in higher after-tax returns for investors.”
The tax efficiencies of ETFs, along with their low costs and increased trading flexibility, make them a top pick for our client investment portfolios. For more information on how we construct our portfolios that we manage, click here.