What are ETFs? How do they differ from mutual funds, and what are their relative advantages and disadvantages? How are we using them to manage your portfolio?
ETFs are investment vehicles that are a lot like mutual funds but trade like stocks.
Both ETFs and mutual funds provide instant diversification. ETFs are generally designed to replicate the performance of specific underlying indexes, such as the S&P 500 Stock Index or the Barclay’s Capital Aggregate Bond Index. Like mutual funds, an ETF share’s net asset value (NAV) is derived from the aggregate value of the underlying securities held by the ETF. Like stocks, ETFs can be traded throughout the day.
ETFs are much more tax efficient that mutual funds. Mutual funds distribute their capital gains directly to shareholders. The legal design of ETFs allows certain capital gains to not be distributed, but instead serve to increase the ETF’s share price. Investors realize such capital gains only when they sell their ETF shares, and they can thus beneficially time the tax impact.
The availability of virtually identical ETFs from competing sources allows another tax-advantageous tactic. On occasion, as market values fluctuate, a particular ETF may fall below its cost basis. We can sell the ETF you currently hold, harvest the tax loss, buy another equivalent ETF, and not change your sector exposure — all without infringing on the IRS’s “wash sale” rules.
ETFs can provide an efficient way to achieve proper diversification in portfolios of any size. In addition, ETFs are useful in enabling rebalancing to maintain a desired asset allocation. For these reasons, we establish a “working layer” of ETFs across various asset classes/sectors in virtually every client portfolio.
Read more in our Research Brief on the subject.
We hope you found this informative. As always, we welcome your feedback.