A look at increasingly popular ETFs

The Savage Truth

Exchange-traded funds are far outpacing traditional mutual funds in gathering assets. Last year, more than $280 billion of new investor money flowed into ETFs, a record. About $135 billion was added to ETFs in the first quarter of 2017.

Traditional mutual funds still far outweigh ETFs, with assets of $16 trillion compared to U.S. listed ETFs with assets of nearly $3 trillion, but ETFs are gaining quickly. In 2004, $35 was invested in traditional mutual funds for every $1 invested in an ETF. Today, that ratio is only 5:1.

This growth in ETFs is all the more remarkable because 401(k) plans typically do not offer ETFs, except through a self-directed brokerage option included in relatively few plans. Individual investors are seeking out ETFs in an effort to invest in a sector or segment of the market but also to diversify the risk from investing in just one company in that sector.

If you've missed out on this trend, here are a few things you should know about ETFs:

What is an ETF?

An ETF is a fixed package of like securities. It could represent a sector of the market or stocks from one country, or it could “track” a popular index. Some ETFs reflect commodity prices. Others are packages of bonds from a similar group of issuers. In all, there are 1,736 U.S. listed ETFs, according to the Investment Company Institute.

Who creates an ETF?

The ETF package of securities is created by an institutional sponsor that handles all the administrative work. The three largest ETF sponsors are Black Rock, State Street and Vanguard. The composition of the securities in the ETF does not change, and there is no manager to make buy and sell decisions about what's inside the ETF once it starts trading.

How do you buy an ETF?

The ETF is traded on an exchange, and the price is set by buyers and sellers throughout the day. That is unlike a traditional mutual fund where the net asset value (price per share) is set at the end of the day by combining the closing prices of all the individual underlying investments.

Because the price of the ETF is set by supply and demand, sometimes the share price of the ETF could be higher (or lower) than the value of the securities inside the ETF. But when prices get out of line, big traders will step in to level out the values, except perhaps in times of market crisis.

How do ETF fees and costs stack up?

Some traditional mutual funds charge an upfront commission, while others do not. All have underlying annual management fees, but depending on the mutual fund company, these fees can be very low. ETFs are similar to individually traded stocks. You will pay a fee to buy and sell, but that commission is determined by your brokerage firm. And because ETFs are listed securities, you can also buy them using a margin loan.

What about taxes?

ETFs are traded like stocks, and your gains and losses are subject to capital gains tax rules, just like stocks. Depending on how long you hold the ETF, you could qualify for lower tax treatment on profits. Losses on sales can be offset against gains, and carried forward to future years. When you own a traditional mutual fund (outside your retirement account) you may receive a tax form every year, reflecting gains (or losses) made on the sale of securities inside the traditional mutual fund, and also dividends distributed. These must be added to your tax return.

Of course, if you hold a traditional mutual fund inside an IRA or 401(k) or other qualified plan, there are no taxes owed until you withdraw. At that point, all withdrawals are treated as ordinary income.

If you're a long-term investor, you can stick with traditional low-cost mutual funds and avoid the risks and costs of trading. And that's The Savage Truth.

Terry Savage is a registered investment adviser. She responds to questions on her blog at TerrySavage.com.

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