More About ETFs
An ETF is an investment vehicle that combines key features of traditional mutual funds and individual stocks. ETFs are open-ended funds which like index mutual funds represent portfolios of securities that track specific indexes. A distinct difference is that ETFs trade like stocks and can be bought and sold (long or short) on an exchange and can employ the same trading strategies used with stocks.
ETF shares are created differently than traditional shares of stocks. Traditionally a company issues a set number of shares through an initial public offering (IPO) and then the shares are traded in the secondary market. Volume is an indication of how many shares are available at a given price. ETF shares can essentially provide unlimited liquidity through a process called creation and redemption. ETF shares can be created on-demand by Authorized Participants such as institutional trading desks and other approved market makers. They are released directly into the secondary market. ETF volume is an indication of how many shares have already traded, not how many shares could be traded.
The unique structure of ETFs provides investors with a number of benefits.
- Diversification
- Tax Efficiency
- Transparency
- Modularity
ETFs are an alternative to traditional mutual funds, with expense ratios that are typically well below those of both active and index mutual funds. For example, most iShares Funds carry expense ratios from 9 to 89 basis points which are substantially lower than the average active mutual fund which typically can carry expense ratios over 100 basis points*. While ETF transactions will most likely generate brokerage commissions, their lower expenses may offset those transaction costs for long-term investors.
Since most ETFs track indexes which are comprised of a basket of securities, they inherently provide instant diversification and are expected to reduce capital gains distributions through lower portfolio turnover than actively managed funds. Unlike traditional mutual funds where shareholder activity can contribute to capital gains distributions, an ETF's creation and redemption structure eliminates the impact of shareholder activity on capital gains distributions thereby making them more tax efficient. Of course, if you sell a ETF at a gain, normal tax rules apply.
