A Closer Look at Exchange-Traded Funds

The popularity of exchange-traded funds (ETFs) has mushroomed in recent years. From year-end 2005 through year-end 2014, ETFs issued $1.4 trillion in net new shares.1 An estimated 5.2 million U.S. households held ETFs in mid-2014.

Like a mutual fund, an exchange-traded fund is a basket of securities. Most ETFs are passively managed and track specific indexes, so they’re most closely akin to index funds. But they trade on an exchange like stocks, can be bought and sold throughout the trading day, and can be sold short and bought on margin. The 1,400-plus ETFs available today track a range of indexes from broad market indexes like the S&P 500 to sector- and industry-specific indexes to bond indexes.

Unlike mutual funds, ETFs are not bought from and sold back to the fund company, in most cases. Individual investors buy and sell shares of an ETF through a broker.

The need to trade ETFs through a broker highlights another sharp contrast with mutual funds: the costs involved. The annual expenses of ETFs are often considerably lower than most mutual funds. But, you must pay commissions to buy and sell ETFs. If you plan to make a single, lump-sum investment, your costs may be lower with an ETF. If you want to invest on a regular basis, though, the broker commissions for each transaction can quickly make owning an ETF more expensive than owning a mutual fund.

With a mutual fund, the fund’s managers are sometimes forced to sell securities in order to pay investors who want to redeem their shares. This can result in taxable capital-gains distributions to all shareholders. With ETFs, trading takes place mostly among shareholders, shielding the fund from any need to sell securities to meet redemptions. This generally makes ETFs more tax-efficient than most mutual funds. However, ETFs can and do make capital-gains distributions because they must buy and sell securities to adjust for changes to their underlying benchmark indexes.

An investment professional at Seaside Bank and Trust can help you evaluate your circumstances to determine whether exchange-traded funds are appropriate for you. Call or stop by to schedule an appointment.

1 Source: Investment Company Institute, http://www.ici.org

Terms to Know

Buying on margin: Purchasing securities with borrowed money, using the shares as collateral.

Selling short: Borrowing a security from a broker and selling it, with the understanding that it must later be bought back and returned to the broker. This technique is used by investors who hope to profit from the falling price of a security.

Passive management: An investment strategy that seeks to match the risk and reward characteristics of a market index by mirroring its composition.