An ETF is much like a mutual fund, but much more complex.
Like a mutual fund, an exchange-traded fund pools the money of many investors and purchases a group of securities. Like index mutual funds, most ETFs are passively managed. Instead of having a portfolio manager who uses his or her judgment to select specific stocks, bonds, or other securities to buy and sell, both index mutual funds and exchange-traded funds attempt to replicate the performance of a specific index. However, a mutual fund is priced once a day, when the fund’s net asset value is calculated after the market closes. If you buy after that, you will receive the next day’s closing price. By contrast, an ETF is priced throughout the day and can be bought on margin or sold short–in other words, it’s traded just as a stock is.
An ETF is expected to approximate the performance of the index it tracks, but it may slightly underperform the index due to administrative costs. Less heavily traded ETFs may actually have market values that are significantly higher or lower than the underlying values due to the principle of supply and demand. For example, if a particular sector has fallen out of favor, demand for shares of an ETF in that sector may fall out of favor as well. This could cause the ETF’s price to fall further than the underlying value of the fund’s actual shares. And, like all securities funds, past performance is no guarantee of future results.
There are many factors to consider in evaluating an exchange-traded fund.
- Look at the index it tracks. Understand what the index consists of and what rules it follows in selecting and weighting the securities in it. Two ETFs that seem to be similar may in fact be very different.
- Look at how long the fund and/or its underlying index have been in existence, and if possible, how both have performed in good times and bad.
- Look at the fund’s expense ratios. The more straightforward its investing strategy and the more widely traded the securities in its index are, the lower expenses are likely to be. For example, an ETF using futures contracts is likely to have higher expenses than one that simply replicates the S&P 500.
- Check on how the fund’s returns will be taxed. Depending on what it invests in and how the ETF is structured, returns may be taxed in a variety of ways. For example, an ETF that invests directly in gold bullion will be subject to the 28 percent maximum tax rate for collectibles. An ETF that uses futures contracts, as many commodity ETFs do, may distribute both long-term and short-term capital gains. A bond ETF pays interest, which is taxable as ordinary income.
You should carefully consider the investment objectives, risks, charges, and expenses of exchange traded funds, which are included in the prospectus available from the fund. Read it carefully before investing.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts and index tracking errors