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ETF Education

What is an Exchange Traded Fund (ETF)?

ETFs combine many of the benefits of an index mutual fund with the flexibility of stocks. Like mutual funds, ETFs enable investors to invest in a pool of securities in one transaction. And similar to stocks, ETFs are listed on a stock exchange so they can be purchased through a brokerage account. ETFs offer stock-like trading features enabling investors to trade throughout the day, purchase on margin, use limit and stop orders and even short-sell.

What is an ETF?
 

Increased Popularity of ETFs

Popularity of ETFs

ETFs vs. Index Mutual Funds vs. Stocks

Though they share features of both index mutual funds and stocks, ETFs have some unique characteristics that distinguish them from other investment vehicles. Use the chart below to compare attributes of all three investment types.

Attribute Exchange
Traded Funds
Index
Mutual Funds
Stocks
Diversification* Varies Varies  
Continuous Pricing

 

Track the securities of a particular index

 
Can be sold short

 

Can use limit and stop orders

 

Trading costs for each transaction

Varies

Transparency

Varies

Lower expense ratios

Varies  

Why ETFs?

Broadly used by institutions, advisors and individual investors, ETF usage continues to grow. ETFs have evolved beyond “cheap beta” strategies and seek to provide investors with better portfolio building blocks. ETFs have the potential to provide numerous benefits by offering access to a large variety of asset classes and themes which may not be easily available through other investment vehicles. Some of those advantages include:

Trading flexibility and convenience

 

ETFs offer continuous pricing and the ability to trade throughout the day, unlike most mutual funds, which are traded at the end of the day.
ETFs enable investors the opportunity to purchase on margin, trade using limit and stop orders, as well as short-sell, even on a downtick.7

Less expensive
 

 

In general, ETFs have lower annual expense ratios than other investment products.8

Diversification*
 

 

ETFs provide broad diversification across securities in a single purchase.

Transparency
 

 

ETFs are required to disclose their holdings daily, allowing investors to see the underlying securities.

Tax efficiency
 

 

ETFs offer the potential for high tax efficiency because they tend to generate fewer capital gains than traditional mutual funds. ETFs are not required to sell securities to meet investor redemptions. Instead, investors interested in redeeming shares sell them on the exchange to another investor. Of course, selling shares may generate capital gains or losses for the ETF investor.

Fully invested
 

 

Because ETFs trade on exchanges, no cash is needed to meet redemptions. This results in ETFs being fully invested in the underlying securities with the ability to fully participate in market movements without cash drag.



 

How to Use ETFs

With a wide variety of available ETFs offering exposure to both broad and narrow asset classes, ETFs can be utilized in a portfolio in a number of ways. A few popular uses are shown here.

Core Positions

ETFs can serve as a solid building block in asset allocation strategies due to their broad exposure to market segments.

Satellite Positions

ETFs can be used to target specific segments of the market and complement core holdings.

Active Investing

Active investors appreciate the intraday price, ability to trade continuously during market hours. Transaction costs need to be watched for active strategies.

Tax Management

ETFs are popular for tax loss harvesting strategy that enables investors to harvest a tax loss yet stay invested in the particular market segment.9

Cash Equitization

When investors are unsure where to invest, they can use ETFs as a “parking spot” for cash to stay invested the market until it is time to make an investment selection.

Bond Laddering

Defined maturity ETFs enable investors to cost-effectively build bond ladders that are more diversified than those using traditional bonds.
Learn More

Types of ETFs

With more than 1,762 ETFs in the U.S.10, there are numerous choices available for today’s investor. From broad-based exposure for the core of a portfolio to ETFs that capture a particular portion of the market, ETFs are a convenient and inexpensive way to get market exposure. The following is a sample of broad categories of ETFs, though as the industry grows, new types of ETFs will no doubt emerge.

Types of ETFs

How Are ETFs Priced?

ETFs trade throughout the day and have a closing price, making their pricing more complex than that of mutual funds. The three prices an investor should understand are:

ETF Pricing Type You Should Know Key Points
Market Price Real-time trading price that the investor pays
  • Determined by:
    • Changes in the value of the underlying securities
    • Forces of supply and demand
    • Opportunity for arbitrage
  • Tells an investor the last trading price
Net Asset Value Tells the investor the true value of an ETF
  • Calculated at market close
  • Real value of the underlying securities = Assets – liabilities/Shares outstanding11
Indicative Indicator Value (IIV) Enables an investor to have a real-time estimate of the NAV.
Also called Indicative Value (IV), Intraday Optimized Portfolio Value (IOPC), Intraday Portfolio Value (IPV) or underlying Trading Value
  • Approximation of the ETF’s NAV
  • Published by an exchange every 15 seconds throughout the trading day
  • Each ETF has its own IIV ticker

* Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
1 2016 ETF Investor Study by Charles Schwab. September 2016.
2 ETF Asset Growth in 2016 Par for the Course, ETF.Com.
3 2016 ETF Investor Study by Charles Schwab. September 2016.
4 FPA 2015 Trends in Investing Survey. April 2016.
5 RIA Advisor Benchmarking Trend Report. May 2016.
6 https://www.statista.com/statistics/278249/global-number-of-etfs/
7 There are special risks associated with margin investing. Investors may be called upon to deposit additional cash or securities if their accounts decrease; this strategy may not be suitable for all investors.
8 Transaction costs of frequent trading can offset the benefits of low expense ratios.
9 This information does not construe tax advice. Please consult your tax advisor for more complete information prior to using this strategy.
10 SOURCE: ICI, May 2017.
11 Only large institutions, known as authorized participants, transact at the NAV in ETFs, in large blocks called creation units.

Have You Explored ETFs?

This educational piece discusses the origin and growth of ETFs, as well as their features and benefits.





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