What is an ETF?

What is an ETF?

ETF stands for Exchange Traded Fund and are funds that trade on an exchange like a stock, hence the inclusion of ‘trade’ in the name. ETFs are also easy to purchase, are often low-cost and are a tax-efficient way to invest your money.

A Very Quick History Lesson

So where did they come from? ETFs are basically another step on the evolutionary ladder of investment instruments that started with stocks. It was a desire to build an affordable yet diversified portfolio of stocks that led to the invention of the mutual fund more than 90 years ago. And mutual funds in turn brought about index funds 40 years ago, which in turn evolved into ETFs, the first of which was introduced 23 years ago in 1993. With each of these innovations the consumer got a bit more value, and in the case of the ETF this has meant both lower fees and the easy ability to build a diversified portfolio.

How Do ETFs Work?

ETFs track an index the same way an index fund does but ETFs move up and down in price during the trading day like stocks. And ETFs generally have lower fees and are more liquid than mutual funds. Another advantage is that while some index funds have an exit fee or load fee, ETFs typically do not.

Another difference between an ETF and an index or mutual fund is that an ETF owns the underlying assets, which can be shares of stock, bonds, commodities, etc. In turn the ETF divides ownership of those assets into shares and it is those shares that you as an investor purchase. As an ETF shareholder you are also entitled to a proportion of any profits, which are usually in the form of earned interest or dividends.

A significant advantage of ETFs is their tax-efficiency. The capital gains incurred from sales that occur within the fund aren’t passed on to shareholders, as is commonly the case with mutual funds.

Why are ETFs cheaper?

Part of the explanation for this how popular ETFs have become in the last decade. According to the Investment Company Institute there are now more than 1600 ETFs (from more than 70 providers), which is an increase of greater than 1,000% during the last 10 years. In that same period of time, ETF assets grew by 30% annually and now represent $2.1 trillion.

This broad popularity has brought economies of scale to bear for the consumer, meaning lower selling costs and lowered expense ratios for similar levels of profit. And the increased competition has driven many ETF expense ratios below 0.15%, and some are below 0.10%.

ETFs Are Also Enabling Innovation

Since ETFs can be traded electronically on exchanges they are allowing new providers like the automated investment services Betterment and Wealthfront to develop new services based on technology that were once only available to the very wealthy. One such service available from both is continuous tax-loss harvesting. This technique allows an investor to use previously unrecognized investment losses and harvest them to offset taxes due on other gains and income.

Disclosure

Nothing in this article should be construed as investment advice, or a solicitation or offer, or recommendation, to buy or sell any security. Investing in mutual funds, exchange traded funds, and other securities carries risk of all or part of the amount invested. Past performance is no guarantee of future results. FeeX assumes no responsibility for the tax consequences to any investor of any transaction. Investors should confer with their personal advisor or tax professional regarding their particular circumstances.

 

 

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