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5 Things You Should Know About ETFs

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ETFs continue to gain ground as an investment of choice among many individual and institutional investors.  ETFs are similar to mutual funds in that they are pooled investment vehicles and to closed-end funds in that they are traded on a stock exchange like individual stocks.  ETFs, though popular, are often misunderstood by investors.  Here are 5 things you should know about ETFs.

Not all ETFs use conventional underlying benchmarks

The first ETFs were largely index products such as the SPDR S&P 500 (ticker SPY) which tracks the S&P 500 index.  SPY remains one of the most traded ETFs day and day out in terms of volume.

An ETF like SPY is pretty easy to understand.  The underlying holdings mirror the S&P 500 index and performance generally tracks the index less the ETF’s expenses (0.09% according to Morningstar).

With the popularity of ETFs, the growth and proliferation of new vehicles is quite high.  Many of these new ETFs track some “funky” benchmarks.   Market Watch’s Chuck Jaffe cited a Vanguard report that found “1,400 U.S. listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.”   

I suspect this issue will become more prevalent as ETF providers continue to introduce new ETFs in a bid to capture market share and assets.

Some ETFs are based on fads or gimmicks 

The Winklevoss twins (of Facebook fame) recently announced the proposed launch of a new ETF tracking Bitcoin.  Bitcoin is virtual currency that exists outside of governmental regulation.  The ETF faces many hurdles and may never get off of the ground.

Should the ETF ever become available for trading this would be the ultimate in gimmicky ETFs.  I find Bitcoin itself a bit hard to understand.  An ETF tracking this at best undeveloped market would in my mind be a stretch.  As an investor this is the type of ETF that I would seriously question.

There are any number of ETFs and other Exchange Traded Products (ETPs) that just don’t work out.

ETF Liquidity is complicated.

With stocks liquidity and the trading volume of the equity are closely correlated.  While a thinly traded ETF might result in a little less liquidity the real determinant of liquidity with an ETF is the liquidity of the underlying investments that make up the ETF.

For example the SPDR S&P 500 is made up of the 500 largest domestic stocks.  These stocks are highly liquid and generally all have substantial daily trading volume.

By contrast we’ve seen some fairly wide spreads between the underlying net asset value and the market prices of some emerging market ETFs of late.  This is in large part a function of a lack of liquidity of the underlying holdings of these ETFs.

Not all ETF structures are identical

Vanguard’s ETFs are structured as another share class of their mutual funds in most cases.  Many popular ETFs are structured as open-end funds, others are structured as Unit Investment Trusts (UIT).  Many single commodity ETFs are structured as Grantor Trusts.  Exchange Traded Notes (ETN) are actually debt instruments linked to the performance of a currency, a commodity, or an index.

Each of these structures have different characteristics and these characteristics may have an impact on the tax treatment of gains or distributions.  For example some commodity based ETFs have a different ongoing tax treatment than say an equity-based index ETF.

It is important that you understand any such factors of your ETF or ETN to avoid nasty surprises at tax time or undo risks that may be associated with the product’s structure. 

Free commission ETFs may not be the best deal for you 

Schwab, Fidelity and others are offering a number of ETFs that trade commission free.  That’s a good thing, but before jumping on one these offers make sure the ETFs offered for free are the best deal for you.

The benefit of free commissions can quickly be negated by high ongoing expenses.  Trading costs are relatively low at most online and discount brokers so unless you are a frequent trader this really shouldn’t be a factor in the decision as to which ETFs belong in your portfolio.

Additionally buying an ETF that doesn’t fit your investment objectives just to save a few dollars in trading costs is absurd.

ETFs can offer a low cost vehicle to build a portfolio.  I use index ETFs extensively for their low costs and adherence to an investment style as a key building block in my client asset allocation strategies.

Like anything else, however, it is vital that you understand what you are buying and that you invest in ETFs that are appropriate for your investment plan.

I want to thank ETF expert Christian Magoon for his contributions to this post. 

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