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The ABCs of ETFs
Posted in Wealth Management Solutions | Nov 2010 | Comments (0)
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When a paradigm shift occurs, new opportunities arise for those who can appreciate and effectively utilize it. Paradigm shifts in orthopaedics occurred in the last 25 to 35 years with the development of arthroscopic and joint replacement surgery, and exchange traded funds (ETFs) represent a paradigm shift to the investing world. Just as it is hard to imagine orthopaedic practice in 2010 without these standard therapeutic modalities, ETFs provide significant advantages to those who understand them, appreciate them, master them and employ them in their daily practice. ETFs were introduced about 18 years ago. In this article, I will delineate the features that are responsible for their increasing use and popularity as a wealth-enhancing tool.
An ETF is a security that tracks an index, a commodity or a group of assets. In this respect it is similar to index mutual funds, but that is where the similarity ends. ETFs trade like a stock on a stock exchange. Investors are now flocking to this new investment tool, mainly because of lower costs and lower taxes when compared to alternatives. In addition, we see many other advantages to ETFs, including:
- Tax efficiency
- Lower costs
- Diversification
- Enhanced asset allocation and portfolio management
- Trading effectiveness
- Tactical strategies
- Risk management & transparency
Tax Efficiency
A few factors provide tax efficiency to ETFs as compared to mutual funds or other investments, which must sell stocks when clients redeem shares. This can trigger capital gains income and taxes, even if the value of the mutual fund drops. ETFs do not share this problem. Another tax saving feature involves wash sales. Such a sale occurs from taking a loss on the sale of a stock that you repurchase within 30 days. It is possible to circumvent this restriction by selling one ETF and purchasing a second ETF that tracks a similar index.
Cost Efficiency
ETF costs are lower because most are passively managed index funds avoiding expensive managerial fees. Mutual funds are subject to 12b-1 fees, which are annual marketing or distribution fees. ETFs are not subject to these burdensome and inappropriate fees. These fees do not serve investors’ interests or inflate mutual fund costs, and I view them as anachronistic in today's investing environment.
Diversification
ETFs exist that cover almost every equity, commodity, sector, geographic location and debt instrument. Broad-spectrum diversification, so important today in minimizing risks to one’s portfolio, is thereby enhanced.