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Exchange Traded Funds: Making the Choice

By: Investor Solutions

By: Investor Solutions, Inc.

There’s a new kid on “The Street” that claims potential cost savings and greater tax efficiency than traditional index funds: Exchange-traded index funds. You will be hearing lots more about them when Barclays comes to market with an entire family later in the spring. The new iShares will trade on AMEX and track broad range of market indices including Russell mid-cap, small-cap, growth and value along with narrower, industry specific sectors.

What’s the difference?

Exchange traded funds look a lot like index funds, but also a lot like the old closed end fund. Both index funds and ETFs are designed to track specific stock indexes. Neither engages in active management and both experience very low portfolio turnover. But, while mutual funds sell securities to cover redemptions, ETFs trade between investors on the open market. ETFs have no minimum investment requirements while index funds do.

Index funds are re-priced once at the end of each trading day and transactions take place at that net asset value. Exchange-traded funds are priced throughout the day, and like stocks, can be bought or sold almost instantly at market price, or even sold short. This distinction means little to long-term investors, but may be important to traders and speculators.

Tax Efficiency

Index funds are already among the most tax efficient investments available. However, some fear that index fund redemptions may result in a taxable distribution. Exchange-traded fund advocates claim that an ETF is more tax efficient because exchange-traded funds transfer securities between investors and that trading causes no tax consequences to the fund. But, redemptions have not posed such a problem in the real world of index funds. An internal study by Vanguard claims that even in a severe bear market, roughly 30% of fund shares would have to be redeemed before anyone would realize a penny of taxable income. In fact, by selling securities with the highest cost basis, fund companies might actually create taxable loss distributions to investors. Furthermore, both ETFs and index funds pay dividends and are unavoidably exposed to capital gains whenever stocks are moved in and out of the actual index.

Structure

The new open-end structure is a vast improvement over closed end funds, which often traded at substantial premiums or discounts. ETF’s eliminated this problem by allowing institutional investors to redeem shares “in kind” which keeps the ETF trading close to its real NAV.

Closed end funds typically hold dividends in an interest bearing account until the end of each quarter before reinvesting them back into the index, reducing the portfolio’s total return by introducing “dividend drag”. Structuring ETF’s as open-end mutual funds does away with this problem.

Investor Considerations Going Forward

Expense ratios of ETF’s may be very competitive. But, while cost may be an important issue, it’s not the only one. If you’re already fully invested in index funds, dumping them may add additional tax and transaction costs. In addition, consider the investment policies of both. For instance, if either is utilizing derivatives, it may introduce tax issues. Finally, if either is sampling part of the index rather than replicating it, it may introduce tracking error.

The new ETF’s may be especially attractive to investors that wish to track a particular index where there is no index fund available.

Either traditional index funds or ETFs are an excellent tool for building a low cost, tax efficient, global asset allocation strategy. Introduction of the new shares will focus attention on passive investments, and create real cost competition in the market place. That’s good for all of us.