ETF Center

Since their introduction, exchange-traded funds (ETFs) have become a popular investment vehicle and the number of ETFs available has grown rapidly. One way to think of ETFs is as baskets of stocks, like mutual funds, but you can buy and sell them on the exchanges intra-day like stocks. Learn more about ETFs through the ETF Center, powered by Morningstar®. Once confident in your knowledge, as a Siebert client you can review our ETF Research, which includes an ETF Screener and Profiles from Interactive Data Corporation. Quickly review ETF performance data, holdings and other detailed information to help you make an informed investment decision. Logo A look at the difference in investment types and what you
can expect from your investment.
By Morningstar

ETFs have traits in common with mutual funds, stocks, and even closed-end funds. But they also possess important distinguishing characteristics that make them unique investment vehicles. Understanding those unique features is the key to using ETFs well, so let's take a look at what sets them apart from the competition.

The primary difference between ETFs and equities boils down to diversification.1 Stock investors prefer the focused exposure of individual equities. But there are times when you need to spread out risk. You might be quite comfortable holding the stock of an individual company if you’ve done the research and are confident in its prospects. But there are occasions when you may not have such conviction.

For example, it can be difficult to find the information necessary to adequately research foreign stocks or small- and micro-cap stocks. In that case, you could mitigate your risk by turning to foreign or small-cap ETFs for diversified exposure to those markets.

In a similar vein, you may be more assured investing in an area where you have expertise, but are less secure investing outside your comfort zone. If you’re a petroleum engineer, for example, you may have special knowledge that makes you an effective investor in the energy sector. Your industry experience won’t help you much when you’re looking for a health-care stock to round out your portfolio though. A broadly diversified health-care ETF can come to the rescue in such situations by spreading your exposure over a number of stocks.

Of course, mutual funds can serve the same purpose because they also offer one-stop diversification.1 But there are certain areas where ETFs have an edge over most conventional mutual funds. First of all, ETFs enjoy tax advantages. Like all index funds, most ETFs are tax efficient because they keep trading to a minimum, which helps keep a lid on recognized taxable gains. The underlying structure of ETFs kicks their tax efficiency up a notch. When large investors request in-kind redemptions, the ETF manager can offload equity shares with the lowest cost basis, thereby flushing unrealized gains out of the portfolio. Furthermore, because individual investors trade ETFs on the secondary market, ETF managers don’t have to deal with unpredictable shareholder cash flows that can trigger tax consequences.

When it comes to tax efficiency, not all ETFs are created equal. Some track indexes that trade more often. For example, a recent screen shows 35 U.S. stock ETFs with turnover rates that exceed 90%. A fund that trades more often is more likely to generate taxable gains. Furthermore, some ETFs lack tax efficiency because of their underlying investments. ETFs that invest directly in precious metals, such as silver or gold, are taxed as “collectibles” rather than securities. That means gains are taxed at a maximum rate of 28% rather than the current 15% that most taxpayers owe on long-term capital gains on securities.

Furthermore, it's important to remember that ETF trades generate tax consequences. If you sell an ETF at a profit, you’ll owe taxes on that gain. And you pay a higher tax rate if you’ve held that ETF for less than a year, so it pays to keep trading to a minimum.

Not only do ETF investors limit taxes, they also save on expenses because ETFs are some of the best bargains in the investment world. The cheapest ETFs boast microscopic expense ratios of 0.05%. Even in the large-cap space, where cost competition is most fierce, ETFs have an edge. The typical diversified large-cap index fund charges 0.63%, while its ETF counterpart costs 0.42%.

As you might expect, ETFs have a greater advantage in expensive categories. For example, the Morningstar category average for no-load emerging-markets stock mutual funds is 1.66%, compared with 0.64% for ETFs. However, not all ETFs are this cheap. For example, the ProShares Ultra leveraged ETFs charge expense ratios of 0.95%. While there are a few exceptions, most of the time, ETFs trump the competition when it comes to costs. ETFs and mutual funds have risks, charges and expenses, and you should carefully consider such risks, charges and expenses before investing. For a complete discussion of these risks, charges and expenses, and other important information, you should read the prospectus carefully. You can obtain a copy of the prospectus by calling Siebert's Mutual Fund Department at 800-872-0666 or contacting the ETF or mutual fund company directly.

So far, we’ve seen how ETFs compare with stocks and mutual funds. Now let's take a look at how they stack up against closed-end funds. Their expense advantage certainly holds up. The typical closed-end bond fund costs 1.34%, which is significantly more expensive than the category average for intermediate-term bond ETFs, which is just 0.21%. That price discrepancy is largely because closed-end funds are actively managed and consequently have a higher cost structure.

Closed-end funds typically use all the flexibility that active management allows. Many even incorporate leverage into their strategies. In other words, these funds use borrowed money to goose returns. But along with those extra returns come additional risks. In contrast, most ETFs are plain vanilla: You get the index--no more and no less.

A closed-end fund employs leverage to boost its income payout, which brings us to another key difference between ETFs and closed-end funds. The closed-end market is primarily aimed at income-seeking investors, so the vast majority are bond offerings. Meanwhile, the ETF universe is dominated by stock funds.

The final difference between closed-end funds and ETFs relates to premiums and discounts. The market prices of closed-end funds can and do differ substantially from their NAVs. Here's why: Like an ETF, the market price of a closed-end fund is determined by the supply and demand for its shares. But the supply side of that equation is restricted for a closed-end fund because it only issues a fixed number of shares at its initial public offering. In order to bring additional shares to the market, it must issue a secondary offering, which can take months. In contrast, ETFs can issue new shares at any time to authorized participants through the in-kind creation process described earlier. That mechanism is specifically designed to minimize discounts and premiums.

Since closed-end funds don’t have such a process, noteworthy discounts and premiums develop, which brings about both risks and opportunities. If you buy a closed-end fund with a big discount to its NAV and that discount narrows, you can parlay that move into a gain. But the opposite is also true: A discount can grow larger, or a premium can disappear. With an ETF, at least you can expect the market price and NAV to remain very close. Many investors like having that assurance.

1Diversification does not guarantee any particular investment return or result, and does not eliminate the risk of loss.

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