Investing in Exchange Traded Funds

Exchange Traded Funds (ETFs) are a relatively new type of investment vehicle and have become very popular in recent years. Since 2000, investments in ETFs have grown from less than $50 billion to almost $2 trillion at the end of 2014. What started out an alternative to a few index mutual funds has grown into an investment category that includes over 1200 ETFs with investments in everything from stocks to bonds to commodities.

ETFs are investment funds that offer many benefits like mutual funds such as diversification and professional management. However, there are significant differences that are important to understand. Below are some of the similarities and differences.

Diversification

A mutual fund typically invests in a portfolio of stocks or bonds with the investment manager, or portfolio manager, responsible for the buy, sell and hold decisions of the fund. Most actively managed mutual funds focus on a type of investment strategy or segment of the market within which to invest. There are also index mutual funds that are not actively managed and just hold the individual stocks that make up an index, such as the S&P 500.

Most ETFs just hold the components of an index and are not actively managed. An example would be an ETF that just holds the individual stocks of the S&P 500. Other ETFs focus on segments of the market such as small capitalization stocks or stocks within a specific industry. ETFs can also focus on individual precious metals like gold or silver and there are ETFs that own the components of various bond indexes.

In general, the portfolio managers of most mutual funds choose investments that they believe will perform better than the overall market. With ETFs, they often hold the components of an index with an objective of just matching the performance of the index.

Buying and Selling

ETFs are listed and traded on stock exchanges. As such, shares of ETFs can be bought and sold during the trading day just like stocks in a brokerage account. Mutual funds are only priced after the close of the day's trading and all purchases and sales take place at that time. Many mutual funds are offered

Fees and Commissions

Because most ETFs are not actively managed, the level of asset management fees is quite low. Mutual funds usually have higher asset management fees, other than index mutual funds that generally also have low fees.

Buying or selling ETFs is like buying or selling individual stocks through a brokerage firm and commissions are charged. Some mutual funds are no-load and can be purchased directly from the mutual fund company without commissions. Mutual funds purchased through a stock brokerage firm typically have commissions charged on their purchase.

In general, ETFs will have lower asset management fees but with commissions charged when bought or sold. Mutual funds will usually have higher asset management fees, but may not have commissions if purchased on a no-load basis from the mutual fund company.

Levels of Risk

All investments, including ETFs and mutual funds involve risk. As the popularity of ETFs has grown, highly focused ETFs have been created that can involve leverage or the use of futures within the ETF resulting in greater risk. It is important to carefully investigate all investments before making the investment and to be sure you fully understand the risks.

Income Tax Implications

With most ETFs, the taxation is like that of owning an individual stock or bond. The brokerage firm where the ETF is held simply includes the information on the Form 1099 sent early in the year. When the ETF is sold, it is treated like a stock or bond with the difference between the purchase price and the sale price reported as a gain or loss.

The taxation of mutual funds is somewhat different. While the dividends and interest are reported on Form 1099, mutual funds are also required to distribute net realized capital gains resulting in the reporting of that gain even though the mutual fund shares had not been sold. This results in the necessity to keep track of the resulting adjustment of the owner's cost basis. Most mutual funds and brokerage firms handle this for investors.