Last week we chronicled the evolution of investment portfolio diversification, from individual stock buying to Mutual Funds, and more recently, into Exchange-Traded Funds, or ETFs. Conceptualized in 1989, by 2003 there were 276 publicly-available ETF offerings. As investor acceptance broadened, new funds were launched by both existing and startup financial services companies. As of February, 2022, statista.com identified 8,754 worldwide ETF offerings, spanning about 70 categories.
Early ETFs emulated Market Indices, such as the S&P500 Index. From humble beginnings arose Sector Funds, created to represent market sectors for investors favoring Modern Portfolio Theory-style Sector diversification. Success breeds imitation, as the saying goes, and soon ETF companies of all types were branching into bonds and other arenas. Fixed-income, commodities, foreign equities and bonds, real estate, and eventually leveraged ETFs emerged and became mainstream investment offerings.
Growing popularity of ETF investing was due to several factors, including instant diversification, low ownership cost, flexible trading (during market hours), and tax efficiency. A single ETF share represents ownership of every asset in the fund, in proportion to the fund’s holdings. The very name Exchange-Traded Fund signifies that shares are bought and sold among individual investors at lightning speed during trading hours. But perhaps the most desirable feature of the ETF is tax efficiency.
One common complaint regarding traditional mutual funds is a legal requirement that the fund must distribute to shareholders (at least annually) all dividends and capital gains realized by the fund during the year. For fund shares not held in tax-deferred or tax-exempt accounts, these distributions are taxable when received. Many mutual fund investors prefer to reinvest their distributions into new shares, which the fund company will do automatically, and at no cost. For those owners, income taxes must be paid outside the fund.
Understanding tax features of the mutual fund industry, pioneers in ETF development received from IRS a requested exemption from the annual distribution requirement, eliminating the annual taxation on unsold shares. That is not to say that no ETFs pay dividends, as many choose to do so. The voluntary nature of dividend and capital gain distributions allows potential shareholders to evaluate their own tax strategies, and to choose ETFs that match their goals.
No short Blog Post could describe all the complexity of any investment vehicle, but an understanding of the workings of ETFs is instrumental in creating long-term portfolios with specific features for the investor.
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