I have been asked this question many times, and it is usually followed by, “what’s the difference between an ETFs or a Mutual Fund?”. This post is a quick overview of what an Exchange Traded Funds or better known as a ETFs are, and how it stacks against a mutual fund.
Similar to mutual funds, ETFs hold a diversified portfolio of stocks, bonds and other asset classes. Essentially, ETFs are a version of mutual funds, packaged by Wall Street as tradable stocks for you and I, the average investors.
ETF’s do have some benefits over mutual funds, and those include, but not limited to, lower fee structure, ability to diversify, increased flexibility, increased transparency, and better tax efficiency.
Lower fee structure
Since ETFs function essentially as an Index fund, as they track a specific sector by holding assets in equal weight, or a very close approximation. For instance, the first ETF, the Standard & Poor’s Depositary Receipt (better known as the SPDR, or Spider) tracked the S&P 500, first began trading in 1993. Since, we’ve seen an onslaught of new ETFs that track all sorts of different sectors.
Since ETFs are to follow a specific sector or an index, they are essentially passively managed with little to no turnover. Thus, unlike mutual funds, resulting in significantly lower annual fees. To put this in perspective, mutual funds often charge somewhere between 1-5% per annum, while ETF fees range between 0.2 – 0.08% or lower.
Ability to invest in a diverse group of asset classes
ETFs allow investors to invest in such a diverse group of asset classes. Investors are now able to not only buy different sectors, such as technology, financials, services, healthcare, consumer goods…etc. ETFs also provide a gateway for investors to enter commodities, such as oil, gold as well as foreign currencies. This allows for the small time traders and investors to create diversified portfolios like never before.
ETFs have an increased flexibility that allows the investor to buy and sell during the trading hours. Unlike a mutual fund, the price of an ETF fluctuates throughout the trading session, and it allows the traders to get in and out of various sectors with a simple click of a mouse. This flexibility gives the investors the ability to buy and sell at a desired price.
Like explained above, at any time you can open your computer and look at the price of an ETF, and that will be the most up-to-date price. This isn’t the same for mutual funds or index funds. Additionally, the portfolios of mutual funds are not always transparent – investors may see what the fund is hold only about twice a year as the fund delivers this list to their investors. Mutual funds are able to buy and sell everyday, however, investors only get a snapshot of their holdings ever so often.
ETFs provide the transparency of their holdings and the value of that group of asset over the trading session. Thus, giving the investors the ability and fluidity needed to enter and exit different asset classes.
Better tax efficiency
Unlike mutual funds, capital gain taxes for ETFs are not bound to the pool of investors. To clarify, all profits are capital gains, and profits gained by a mutual fund are passed through the fund onto the shareholders. When a shareholder earns capital gains, he/she must pay capital gains taxes. If you are in a mutual fund for a year or a decade, you still have to pay taxes every 12-months.
The opposite is true for ETFs. investors only pay taxes on their capital gains when their sell their shares. This is significant as investors don’t have to pay out a portion of their investment principle to pay for taxes every year – thus leaving more capital for growth. Thus, those who prefer to buy and hold for a long period of time may actually find themselves in a lower tax bracket.
What are Leveraged ETFs?
The simple answer is highly risky assets. The long answer is – leveraged ETFs are ETFs that use financial derivatives and debt to amplify the returns of their underlying index. Leveraged ETFs are available for almost all indexes. The aim of the leveraged ETF is hold a constant amount of leverage during a specific time frame – usually in a 2:1 or a 3:1 ratio.
For instance, when SPY (ETF that tracks the S&P 500) goes up 1% the SPXL – the DIREXION DAILY S&P 500 BULL 3X- goes up 3%, and vice versa. Investors use these methods to increase their profitability and returns, however, they expose themselves to a higher degree of risk.