What Is An Exchange Traded Fund ETF

For many people, their investing desire is to have a stable portfolio of stocks and investments.

An investment that will not get hit too badly in a bad economy, and one that will not get caught in a hyper growth cycle and lose all its earnings in only a few months.

An Exchange Traded Fund is an investment that trades like a stock. ETF’s like many other funds pull together money from investors into a group of different investments.

These include stocks, bonds, and other securities. By spreading the funds money into different securities ETF’s can equip investors with the important diversification they’re looking for that helps balance risk.

Quick Video Explains: What Are ETFs?

ETFs Trade On The Stock Exchange Therefore They’re Bought And Sold Like Stocks

From one fund in 1993, the ETF market grew to 102 funds by 2002, and nearly 1,000 by the end of 2009 and there are around 7,000 ETFs traded worldwide in 2021.

Mutual fund inflows have typically exceeded ETF inflows during years where market returns are positive, but ETF net inflows are superior in years where the major markets are weak.

Each ETF has a different aim. Some invest in a variety of stocks and bonds. While others replicate the performance of a stock index like the Dow Jones or S&P 500.

Other ETFs track performance of a particular market sector like technology or pharmaceuticals.

It’s important to know that different ETF’s offer different amounts of diversification.

Those that represent market sectors offer less diversification than those that replicate an index.

Some ETFs pay dividends, but not all. A good deal of re-invest earnings into the funds holdings.

Looking at the dividend yield allows investors to see if the ETF pays dividends. This yield is the amount the fund pays out compared to the current market of a share.

ETF Funds Have Other Qualities That They Draw Investors To

Just like there are a variety of mutual funds, there are a variety of ETF’s.

Compared to many mutual funds which can require a minimum and enormous investment, ETF investors can just buy a single share and pay commissions and fees.

They almost never incur yearly capital gains taxes like mutual funds can. Investors only pay taxes when the ETF shares sell through a profit.

ETF’s aren’t actively managed. This passive management creates lower management fees. Lower than popular mutual funds.

Another way to look at an ETF is if we combined an index fund and stock. It would have traits from both the index fund and the stock.

The significant thing about ETF’s is the investor need not be wealthy. They are simple to buy, sell, and own.

Multi-trillions of dollars in ETF’s are traded every year. It’s clear they are going to be part of the world of investing and trading for many years down the road.

What Are Alpha Seeking ETFs

Alpha-seeking ETFs are equity funds attempting to outperform the market with various investment strategies.

They show a vast range of investment aims, from hedged funds mimicking strategies as the Alphaclone Alternative Alpha ETF (ALFA) to funds following proprietary stock picking strategies as the VanEck Vectors Morningstar Wide Moat ETF (MOAT).

With 240 ETFs traded in the U.S. markets, Alpha-Seeking ETFs gather total assets under management of $34.37B.

The largest Alpha-Seeking ETF is the ARK Innovation ETF ARKK with $9.85B in assets.

In the last trailing year, the best performing Alpha-Seeking ETF was the ARKG at 164.57%.

How Defined Outcome ETFs Work

Defined outcome ETFs aren’t exactly new with the first funds of this type launched by Innovator in 3rd quarter 2018.

In fact, the concept behind them is rooted in annuities and structured products.

We can use defined Outcome ETFs in portfolios for several purposes related to taking some risk off the table.

These strategies ultimately allow investors to stay in the market when volatility is up because of a built-in “buffer” from market losses.

That’s important, because it can base many large market gains on single-day movements, and if you’re out of the market for even just a few days, you could miss out. Market timing is a loser’s game as most seasoned investors know.

Defined outcome ETFs also have implications for retirement investing when a fixed income isn’t performing as it has done historically.

Traditionally, investors reduce their equity exposure as they get closer to retirement and shift more of their portfolio into fixed income, seeking stability and income.

There are certain similarities that these funds seem to have in common.

All invest in Flexible Exchange (FLEX) options based on an index or ETF.

The vast majority invest in FLEX options tied to the S&P 500 Index or ETFs that track it, though Innovator offers some that track other key indexes like the MSCI EAFE Index or the Russell 2000 Index.

There are also versions of these funds that offer exposure to fixed income.

All the issuers of these funds have tools available on their websites to let you know what limits you’ll be getting on the day you purchase one of their funds.

Tax Efficiency With ETFs

One of the big selling points for ETFs as investment vehicles is that they are much more tax efficient than their competing mutual funds.

If a mutual fund or ETF holds securities that have appreciated in value, and sells them, they will create a capital gain.

These sales can result either from the fund selling securities for a tactical move, because of a rebalancing effort, or to meet redemptions from shareholders.

We know that by law, if funds accrue capital gains, they must pay them out to shareholders at the end of each year.

As a general rule, ETFs do much better than mutual funds for paying out capital gains.

Most ETFs don’t pay out any capital gains. Data shows just 6.2% of U.S.-listed ETFs paid out a capital gain in 2018, but over 60% of mutual funds did as well.

Because they’re index funds, most ETFs have very little turnover. Far fewer capital gains than an actively managed mutual fund would. 70% of mutual funds are actively managed.

However, ETFs are also more tax efficient than index mutual funds, thanks to the magic of how new ETF shares are created and redeemed.

When a mutual fund investor asks for their money back, the mutual fund must sell securities to raise cash to meet that redemption.

But when an individual investor wants to sell an ETF, they sell it to another investor like a stock.

No hassles and no capital gains transaction for the ETF.

When an authorized participant (AP) redeems shares of an ETF with an issuer it gets better.

When an AP redeems shares, the ETF issuer doesn’t rush out to sell stocks to pay the AP in cash.

Instead, the issuer pays the AP thus delivering the underlying holdings of the ETF itself. This no sale means no capital gains accrued.

The ETF issuer can even pick which shares to give to the AP. This means the issuer can hand over the shares with the lowest possible tax basis.

This leaves the ETF issuer with only shares purchased at or even above the current market price while reducing the fund’s tax burden and ultimately resulting in higher after-tax returns for investors.

The system doesn’t work so smoothly for all ETFs, however. Fixed income ETFs, which have more turnover and often have cash-based creations and redemptions, are less tax efficient than their equity akin.

But all else equal, ETFs win hands-down, with over two decades of history showing they have the best tax efficiency of any fund structure in the business.

This explains most of the Pros of ETF funds.

What About The Cons Of ETF Funds?

There are commissions and trading fees. Experts have argued that ETFs trade as short-term speculations.

This makes frequent commissions and other trading costs take away from investor returns.

There can be limited diversification sometimes. Most ETFs, say some experts, do not provide sufficient diversification.

Other authorities, with opposing views, say that there are widely diversified ETFs, and holding them for the long term can produce profits.

ETFs tied to unknown or untested indexes are a major negative aspect of investing in these instruments many investment advisors will tell you.

Conclusion:

ETFs generally offer a low cost, widely diverse, tax efficient method of investing across a single business sector, or in bonds or real estate, or in a stock or bond index, providing even wider diversity.

Commissions and management fees are relatively low, and ETFs may be included in most tax-deferred retirement accounts.

On the negative side ETFs which trade frequently, incurring commissions and fees have limited diversification in some ETFs and some ETFs may be tied to unknown and or untested indexes.

Guiding Cents Staff

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