Exchange-Traded Funds (ETFs) are similar to Mutual Funds, which should surprise no one who realizes that one business grew out of the other. Each begins as a collection (pool) of financial assets, typically stocks, and bonds. Once assets are in position, differences begin to take shape. While traditional Mutual Funds have been in existence for over 100 years, ETFs recently celebrated 30 years since their inception in 1993.
I like to picture a Mutual Fund, Exchange-Traded Fund, or similar asset pooling technique like this. Using a stock fund as an example, picture a stack of stock certificates, representing the entire holdings of the fund. Now, take a big electronic knife to slice the stack, cutting a series of equal vertical pieces, each containing a small part of every asset. Individual or institutional ownership is represented by the number of shares held at any point in time.
Distinctions include methods of buying and selling shares, the tax treatment of income, gains, and losses resulting from the ownership, and costs incurred while shares are owned. By law, Mutual Fund shares are bought from, and sold to, only the Fund Company itself. Trading is limited to off-hours, meaning when the major Stock Exchanges are closed. ETFs are bought and sold among and between traders, over an Exchange, during trading hours.
Costs of ownership favor Exchange-Traded Funds, which require less day-to-day management, partially due to trading simplicity. Unless a particular Mutual Fund consistently outperforms a similar ETF over time, most investors see no point in absorbing the extra internal costs of the Mutual Fund.
Perhaps the most significant feature of ETFs is the advantageous tax treatment granted by the IRS to owners of ETF shares. Traditional Mutual Funds are required by law to distribute to shareholders, at least annually, all net dividends and capital gains realized within the fund itself over a specific time period. For shares held in taxable accounts, this creates a tax liability for the owner. Since many owners choose to reinvest their payouts in new shares, the taxes must be paid from other sources.
ETFs are not required to distribute dividends and gains, and many choose to hold back the cash to grow the share value. Taxes are paid when shares are sold, generally with proceeds from the sale. During times of down markets, shares are often sold below their cost, generating a tax loss that can be used to offset gains from other sources, or from differing time periods.
Investors everywhere are discovering that ETFs are increasingly useful in portfolio construction and management. Happy Birthday, ETF Industry. We celebrate your very existence.
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