What The ETF?
The scoop on exchange traded funds and the benefits of using them.
Mutual funds have been around for a long, long time. Since 1924, in fact. July 31st will mark the centennial anniversary for the first ever mutual fund. Imagine being the investment advisor launching the first ever mutual fund five years before the 1929 market crash. Oof. It is noteworthy that the fund is still around today.
Fast forward the historical clock to 1993 and we see a new kid on Wall Street, the Exchange Traded Fund (ETF). The brainchild of the American Stock Exchange and State Street Global Advisors, the idea was to create a low-cost way to purchase a basket of securities that mirrored an index, but to allow the end investor to retain direct access to secondary markets for liquidity.
It sounds complicated, and believe me, it is. For this reason, among others, it took more than two decades for ETFs to catch on among mainstream investors. Traditionally, mutual funds reconcile shareholder records at the end of the day, directly conducting market operations to absorb inflows and outflows. This is a relatively simple structure that is intuitive to understand.
The comparison between mutual funds and exchange traded funds go beyond transaction mechanics. For a more comprehensive comparison, please see the footnotes below.
By contrast, ETFs utilize a two-layer process known as the creation/redemption process, illustrated above. Like stocks, investors can trade ETFs throughout the day in the secondary market (i.e. via exchanges like the NASDAQ or NYSE). To enable this feature, order flow is sent from the exchange to the primary market where fund sponsors and Authorized Participants (APs) work together to create and redeem shares of the fund.
APs are the financial services companies contracted to conduct market operations on behalf of the fund sponsor, buying, selling, and exchanging securities. The ETF sponsor directs the APs as the investment advisor. Simple, right?
For most people, how the sausage is made isn’t what’s important. It’s how it tastes. The verdict is in, and many investors prefer the taste of ETFs over traditional open-end mutual funds because of tax-efficiency. It’s like adding a dash of salt to your portfolio.
There’s a tiny tax devil within the details of the creation/redemption process of an ETF. APs can conduct market operations independent of capital gain tax liabilities. In other words, if an AP buys stock Y at $50 per share, then two days later sells stock Y for $60 per share, this does not trigger a tax event.
Now, let’s say the fund sponsor decides to replace stock Y with stock Z, and stock Y has a substantial capital gain. The manager processes an in-kind exchange of its stock Y position, imbedded gain and all, for an equal value of stock Z. Boom, guilt-free rebalance without the aftertaste of capital gains taxes.
This same transaction within a standard mutual fund would cause a capital gain tax to be realized, which would be distributed to all shareholders at the end of the year via a 1099, unless held within a tax-sheltered account such as an IRA. Like my grandmother serving potatoes for Sunday dinner, you are getting them whether you want them or not.
This does not mean there are no capital gains taxes within ETFs. You would have better luck escaping earth’s gravity. It just means that the end investor can choose when they should pay capital gains tax. Ultimately, the gain is embedded in the share price of the fund which can be deferred over time.
Nonetheless, ETFs are becoming the popular choice amongst the more tax conscience investors. They permit more flexibility around tax planning and avoid inefficiencies such as short-term capital gains taxes.
This most certainly does not make standard open-end mutual funds obsolete. There are good reasons for investors to use both. As always, consult with your financial professional to learn what’s right for you.
Stay tuned and stay invested!
Footnotes:
Open-end mutual funds and Exchange Traded Funds may differ from one another in the following areas:
Investment objectives
Both mutual funds and ETFs – investment objectives may vary, depending on the funds’ investment policy. Investors should refer to a fund’s prospectus for detailed information regarding a specific fund.
Sales and Management Fees
ETF – management fees are assessed daily as part of the creation/redemption process. Transaction fees are assessed by the broker, independent of the fund manager.
Mutual Funds – management fees are assessed daily as part of the NAV calculation and may also include additional fees, such as 12b1 fees. Investors may also be subject to up-front or back-end selling fees known as loads.
Liquidity
ETFs can be traded intraday. ETFs are priced every 15 seconds throughout the day to keep the price close to the NAV2 of its underlying holdings.
Mutual Funds are priced once per day after markets close as part of the Net Asset Value calculation process (NAV). All trades are priced at NAV the day of the order. Orders placed after market close are priced at the NAV of the next market day.
Safety
Both mutual funds and ETFs – the safety of a particular fund will vary, depending on the nature of the underlying investments and the investment objectives of the fund. Investors should seek out the prospectus of a fund for detailed information regarding safety.
Guarantees
Both mutual funds and ETFs – neither fund structure permits a guarantees of performance or principal. Investors may be subject to fluctuations, including the potential loss of principal.
Fluctuation of Principal and/or Returns
ETFs – investors in exchange traded funds will experience intraday fluctuations in principal. The degree of which will depend on the nature of the underlying investments.
Mutual Funds – investors will experience fluctuations in principal daily, depending on the closing NAV price of the previous trading day. In effect, investors will see a change in value with a 1-trading day delay. Again, the degree of which will depend on the nature of the underlying investments.
Tax Features
ETFs – the creation/redemption process of an ETFs can afford a more tax efficient fund structure in that capital gains can be deferred by direct exchanges to/from Authorized Participants. In essence, this allows investors to defer their capital gains at their discretion. Not every ETF utilizes this process. Investors should consult the fund prospectus for details.
Mutual Funds – capital gains/losses, interest income and dividends are attributed proportionately to all shareholders in the year realized. This is regardless of when the investor purchases the fund.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Individual tax and legal matters should be discussed with your tax or legal professional.
Securities offered through LPL Financial LLC. Member FINRA/SIPC. Advisory Services offered by National Wealth Management Group LLC, an SEC Registered Investment Advisory and separate entity from LPL Financial LLC.