Home White Papers Are ETFs Right For You?

Ever feel like you are being “acronym-ed” to the point of distraction?   The financial world, with its own brand of terminology, has been accused of much obfuscating.  Consider the term “ETFs,” which stands for Exchange Traded Fund.  These securities enjoy similar trade characteristics with stocks, where the price is determined throughout the trading day by investor demand.   As such, most are highly marketable and may also be margined (e.g. collateralized for loan purposes at a brokerage).

One of the most common ETFs are “Spiders,” which follow the S&P 500 Index (NYSE Symbol: SPY). With as little as a single share, investors can own a fund that tracks and trades based on all underlying stocks in the S&P 500 Index.  Since launched in 1993 by State Street Global Advisors have gained popularity to the point where total ETFs assets have surpassed the $1.5 trillion mark 1 .

While many investors have embraced ETFs for their transparency, low cost and tax efficiency,  ETFs can also provide hedging strategies and an efficient way to access niche assets. With so many investors taking the plunge into ETFs, does this product make sense for you?   The following summarizes key benefits to help you make in a more informed decision:

Transparency. Since ETFs track a specific set of assets or an index, it is usually clear what is being purchased.  Using the “Spider” as an example, investors know they are buying a basket of the 500 stocks that represent the S&P 500 Index.  Transparency helps us build more efficient portfolios because we can diversify among various asset classes and know exactly how much is weighted in each category.  By contrast, open-end mutual funds are allowed to delay announcements of their specific holdings for three to six months, so it is more challenging to know what the fund manager is holding on a given day.

Low Cost:   ETFs typically boast low costs relative to mutual funds as a key advantage.   For example, Morningstar depicts the average US Large Cap Stock ETFs as costing 0.47% in annual operating expense, compared to 1.31% for mutual funds in the same category 2 .  One reason: Mutual funds shares are typically transacted by the fund company itself (e.g. investors purchase and sell fund shares with the fund company itself) rather than on an exchange.   So mutual funds can have greater operating costs. Costs vary between investments, and should be considered before investing. 

Tax Efficiency:    Especially when compared to mutual funds, ETFs can offer tax advantages.  One reason is that mutual funds have more transactions to accommodate shareholder redemptions or to rebalance assets.  By contrast, ETFs accommodate inflows and outflows by using “creation units,” or baskets of assets that approximate the entire ETF’s investment exposure.   So although mutual funds and ETFs are viewed by the IRS in the same light, their different operating procedures can cause a significantly different tax impact for the investor.

For example, new mutual fund investors may find their fund recognizing capital gains occurring earlier in the calendar year, even before their investment was made.  This is because mutual funds accrue gains throughout the year and assign them pro rata to every investor as of a specified date of record (often in December).  By contrast, ETFs typically do not have as much active trading within the fund, so there are less taxable events.  Hence, ETFs generally have a much lower tax impact than mutual funds.  Also note that the sale of an ETF may be subject to capital gains taxes.

ETF’s can also offer an alternative to “wash sales,” a rule specifying that when a stock is sold at a loss, the same stock cannot be repurchased within 30 days of the sale.  So if the stock should rally after the sale, investors could miss out.  By contrast, the stock could be sold, losses realized, then an ETF purchased that relates to that stock’s specific sector. This provides an alternative to the wash sale rule and can allow for uninterrupted exposure to a specific market sector. Please note that investors can repurchase stock within the 30 day period of the sale, but the loss can no longer be realized and is adjusted into the new shares’ cost basis.

Active vs. Passive Management:   Much controversy surrounds the value of active management.  In fact, one of the investment world’s most significant ongoing debates regards the value managers add to the funds they manage. The typical mutual fund manager charges a fee to oversee the underlying fund investments, make trades, and invest according to the fund’s goals. While beyond the scope of this article, suffice it to say that many ETFs do not have an active manager, but rather only replicate a portfolio which often costs much less. Note that there is no guarantee that any investment will meet its stated objectives.

Diversification & Strategies. ETF’s can offer immediate portfolio diversification with lower operating costs.  One strategy finds investors using ETFs to gain exposure to less “mainstream” areas such as precious metals, natural resources, specific industries and/or geographical regions.   These may serve as “satellite diversifiers” to help gain access to those asset classes that may be difficult to purchase individually. Keep in mind that diversification does not ensure a profit or guarantee against a loss.

Another strategy is to construct entire portfolios around ETFs.   The portfolios can be geared toward various risk tolerances, from conservative to growth.  Brokerage firms and advisors may use this strategy and, by adding their oversight to selection and monitoring, can provide a version of low cost, managed portfolios.

Since ETFs trade like stocks, we can utilize the same order tools designed to automatically capture gains and control losses through “limit” orders.  For example, a standing order can be placed to sell the ETF when its price either rises by, say, 10%, or falls by 10%.  By contrast we are unable to do this with mutual funds, since they are transacted by the issuing fund and are priced at day’s end as opposed to intra-day. Please note that transaction fees/commissions can apply to ETF trades.

Risks: While ETFs may be appealing for these and other reasons, it is important they be considered with the  caution that is prudent with any investment. The principal value of ETF shares will fluctuate with changes in market conditions.  For example, because ETFs are priced based on market demand, the actual trading price may be higher or lower than the net value of underlying assets (called “NAV”).  Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.  This could present an additional source of uncertainty or risk that should be considered.  Transaction costs can vary between brokers, and liquidity can vary based on supply/demand.

Since ETFs have grown so quickly, there are new products coming out all the time. There are now leverage products, inverse products, and other complicated structures that may be overwhelming to the novice investor. You also need to be careful if you are investing in a systematic arrangement such as monthly contributions. Since ETFs trade like a stock, they typically incur a cost per trade, So they may not make sense from a cost standpoint. For this type of arrangement you may want to consider mutual funds or a managed ETF portfolio with a brokerage firm.

For these reasons and more, it is important to seek advice from a qualified financial advisor. Any investment needs a thorough review and should be part of a comprehensive plan.  Bottom line:   While ETF’ may make sense in your portfolio, it is important to do the proper research and seek help through the advice of a financial planner when necessary. 

Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Investments mentioned may not be suitable for all investors, and may be subject to special and greater risks. The forgoing is not a recommendation to buy or sell any individual security or any combination of securities. Be sure to contact a qualified professional regarding your particular situation before making any investment or withdrawal decision.  

Investors should carefully consider the investment objectives, risks, charges and expenses of Exchange-Traded Funds (ETFs) and mutual funds before investing. The prospectus and summary prospectus is available from your financial advisor and should be read carefully before investing.

This information is not considered a recommendation to buy or sell any investment or insurance. We strongly recommend an advanced tax and estate planning expert be contacted for further information.  

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Mitchell Kauffman and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice.  

sec.gov/investor/pubs/margin.htm for additional information.

The S&P 500 is an unmanaged index of 500 widely held stocks that’s generally considered representative of the U.S. stock market. Please note that individuals cannot invest directly in an index.  

While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.  

As owner and principal of Kauffman Wealth Services, Mitchell Kauffman has been providing wealth management and financial advisory services to his clients for over 30 years.  An accomplished writer and speaker, Kauffman’s contributions have been published in the Los Angeles Times, Chicago Tribune, and Kiplinger, as well as several local publications.    

He was one of only five financial advisors in the U.S. named to the Advisor Hall of Fame for 2010 by Research magazine.  This honor has been bestowed on only 100 advisors during its 20 year history.  In 2009, he was recognized as one of three Bear Market Stars nationally by Registered Representative magazine in its August 2009 issue, for performance during the economic market downturn.   

Kauffman earned membership in the Raymond James Financial Services, Inc. Chairman’s Council, comprised of the organization’s top advisors.  Membership is based on prior fiscal year production.  Requalification is required annually.   

Kauffman is a CERTIFIED FINANCIAL PLANNER™ and holds an M.B.A. from the Claremont Graduate University, where he served as a graduate fellow under the late Dr. Peter F. Drucker.  He also earned a Certification in Financial Planning and Masters of Science from the College for Financial Planning in Denver, Colorado, as well as a B.A. in Business Economics and Political Science from the University of California at Santa Barbara.  

He is an Instructor of Financial Planning and Investment Management at the University of California at Santa Barbara, Santa Barbara City College, and Pasadena City College. For more information, visit www.kauffmanwealthservices.com or call (866) 467-8981. Kauffman Wealth Services is an independent Registered Investment Advisor and serves clients from two office locations: 140 South Lake Avenue, Pasadena, CA 91101 and 550 Periwinkle Lane, Santa Barbara, CA 93108. Securities offered through Raymond James Financial Services, Inc. member, FINRA/SIPC.

1 As of June 30, 2013 according to Pensions & Investments annual survey