10 Things You Should Know About ETFs

As the exchange-traded world continues to expand, many investors find themselves asking the same questions about how these products work. Of course, not everyone is as vocal about their curiosities, leaving a number of unanswered questions in the space. In an ongoing effort to keep you educated about the ETF world, we mapped out ten questions you may have been too afraid to ask [see also How To Pick The Right ETF Every Time].

1. What Is An ETF?

It seems basic, but as ETFs continue to grow in popularity, more and more investors find themselves asking this question. An ETF is basically an ownership stake in a pool of assets. When an investor buys an ETF share, he or she is buying a small percentage ownership of a large portfolio of stocks, bonds or other assets. ETFs allow a large number of investors to basically “share” in a larger, more diversified portfolio than they could assemble on their own.

2. What’s the Difference Between ETFs and ETNs?

While both are prominent structures for exchange-traded products, there are several differences between ETFs and ETNs that investors should know before investing. First off, ETNs are debt instruments and are at the credit risk of their issuer, whereas ETFs do not face this issue. While it is rare for an ETN to suffer from credit risk, it is worth noting that Lehman Brothers had several ETNs at the time of their demise in 2008.

Next comes taxes. ETNs will always issue a 1099, as will most ETFs. But certain ETFs, like those that hold futures, will issue a pesky K-1 come tax time. Also, ETNs are always taxed at 15% for long-term capital gains and 35% for short-term capital gains; this figure often varies for ETFs. It is also worth noting that ETFs can exhibit tracking error, while ETNs will never incur this issue. Finally, as a debt instrument, ETNs will mature one day and liquidate, by design, back to shareholders. The structure of a product has a huge impact on its exposure.

3. What is Tracking Error?

Tracking error, simply put, is the delta between the performance of an ETF and the change in the underlying index. Perhaps the simplest source of tracking error is the expense ratio of an ETF; funds operating at full efficiency can be expected to trail their underlying index by a margin equal to the bottom line fees charged. Indexes are hypothetical measures of performance that are not directly investable–there is no associated management fee or other expense components.

Sometimes the culprit is thin trading volume, as some products can go days without trading, which does not allow their price to accurately reflect the index at the current time. Other times a rebalancing of the underlying index may mean that the fund does not have enough time to catch up. Read more on how tracking error is caused and how to beat it.

4. What Happens When an ETF Shuts Down?

As more and more ETFs hit the market, it is inevitable that some will be forced to close their doors. It costs money to run an ETF and after a certain point it becomes too expensive for an issuer to keep the product open. An ETF closing is not cause for panic; you’ll have the opportunity to either sell your shares prior to the delisting or to receive your share of cash proceeds. That may be less than optimal; the sale may trigger some tax liabilities, and there are costs associated with redeploying capital. But overall, an ETF closure isn’t really a big deal. Read more about how to handle closures.

google.load('visualization', '1', {packages: ['corechart']}); function drawVisualization() { // Create and populate the data table. var data = google.visualization.arrayToDataTable([ ['Year', 'Launches', 'Closures', ], ['2009', 137, 56, ], ['2010', 231, 49, ], ['2011', 310, 38, ], ['2012', 177, 104, ], ]); // Create and draw the visualization. new google.visualization.ColumnChart(document.getElementById('visualization74221')). draw(data, {title:"ETF Launches and Closures By Year", width:600, height:400, hAxis: {title: "Year"}} ); } google.setOnLoadCallback(drawVisualization);

5. What’s Up With Leveraged ETFs?

Leveraged ETFs and ETNs have been the subject of much debate over the past few years. Many will look at the long-term performance of a leveraged product versus its underlying index, and be left scratching their heads when the returns do not exactly line up with the leverage the fund presented. It is all based on the reset frequency of the product, and most leveraged funds reset daily. This means that the fund is only designed to provide its levered exposure for one trading session, not over a long period of time.

There are some monthly resetting products and some that never reset, but daily leverage is the most popular option currently available. This article takes an in-depth look at reset frequencies and why these trading products are so misunderstood.

6. Does Weighting Methodology Really Matter?

Absolutely. There are many different strategies that encompass the ETF space: equal, RAFI, earnings, revenue, dividend and AlphaDEX are just a few of the methodologies that have struck a chord with investors. The weighting of your fund makes a fundamental difference to the performance of the fund. Take the S&P 500 for example; below we compare the performance of several different funds that all put a different spin on the popular index.

As is clearly evidenced above, though these funds all track the same parent index, the way they slice and dice the holdings makes a big difference on bottom line returns. Check out a more in-depth explanation of the various alternative weighting methodologies.

7. Does a Slight Difference in Fees Matter?

While it may seem like a minute difference, a couple of basis points over time can be a big deal. The ETF industry seems to pride itself on offering the most competitive prices for investors, as a battle of cost-cutting has ensued in the past few years. As a result, some funds, like VWO, have been able to outdo competitors that track similar holdings. One popular comparison comes between two physical gold ETFs, the iShares COMEX Trust (IAU) and SPDR Gold Trust (GLD); the former charges 0.25% and the latter 0.40%.

Consider two different million dollar portfolios, one which is wholly invested in GLD and the other doing the same for IAU (obviously a diversification nightmare, but stick with us). The GLD portfolio will incur annual expenses of $4,000, while its competitor will shell out only $2,500. That $1,500 difference seems minuscule for just one year, but drag it out over a 30-year investment and the difference between fees amounts to $45,000, or 4.5% of your original investment. Saving yourself a quick 4.5% could have been as simple as buying IAU over GLD. Read more about this cost battle.

8. How Are ETFs Treated Come Tax Season?

The answer to this question depends entirely on the underlying exposure of the fund. Some products, like physical precious metals funds, are taxed as collectibles at 28%. Others are given the normal 15/35 treatment, and still others are subject to other rates. Investors will also want to note that structure will often dictate whether or not they are issued a K-1 or 1099 come tax time. Our comprehensive database provides you will all of the tax information you will need to make an informed decision.

9. Why Invest in an Index?

Gone are the days when active management was the best decision for investors. Actively-managed mutual funds consistently fail to beat the market; nearly 86% of the time when expenses are factored in. Index funds provide investors with a better long-term exposure and at a much lower cost to boot. While there certainly are individuals who can beat the market, studies have proven over and over that index funds outperform their competitors the vast majority of the time.

10. Are ETFs Better Than Mutual Funds?

Better is not the right term to use in this situation, despite how frequently this question is asked. Every product is different depending on your objectives, but there are a number of factors that set ETFs apart from their mutual fund counterparts. ETFs are cheaper, more transparent, allow for margin buying and short selling, and offer more control over capital gains, for starters. The list of differences goes on and on, but at the end of the day the only person who can decide which product is better is you. Take a look through some of the key differences between these two investment vehicles.

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Disclosure: No positions at time of writing.

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