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Portfolio > ETFs

ETFs: An Advanced FAQ

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What are the differences between mutual funds and ETFs?

ETFs track indexes which are, in turn, managed professionally and have teams of analysts and economists choosing the securities included in the index and the methodology for measuring the percentage of gain against base. Mutual funds pool investors’ funds and their professional managers select the securities, which the fund buys. The fund charges the investors a percentage of an investment pool for their services. This charge is called the “load.” Typically, the cost of the load for ETFs is lower than that of mutual funds.

ETFs are a much newer investment vehicle and have been available only for the last 20 years. Mutual funds have existed since the 1930s and, as a result, many have a long history with their institutional investors. For a less sophisticated investor, the process of purchasing and redeeming a mutual fund and the longer history of return that is available may be less intimidating.

ETFs appeal to sophisticated investors because they are more nimble. They can be traded throughout the day, purchased on margin and sold short, while mutual funds cannot. ETFs also afford the individual investor access to myriad markets and asset classes.

What is the advantage of owning an ETF rather than individual stocks?

Because ETFs track particular indexes, they mirror the underlying index’s diversification. Diversification is the term used in the financial world for a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind the technique is the theory that a portfolio of diverse investments will both yield a higher return over time and pose a lower risk of loss than any individual investment found within the portfolio.

Studies and mathematical models have shown that, over time, maintaining a well-diversified portfolio will yield a higher return and provide the most cost effective level of risk reduction. Most individual or non-institutional investors have limited investment budgets and may find it very difficult to independently create an adequately diversified portfolio.

Because ETFs are traded as securities on the public stock exchanges, individual and non-institutional investors can purchase shares in an ETF and obtain the benefit of its diversification together with the expertise of the analysts and economists who select the stocks and bonds in the index which the ETF tracks.

As an example, it would be very difficult for most individual investors to purchase shares in each of the companies listed in the Standard & Poor’s 500 index. ETFs can provide a method for individual investors to accomplish this level of diversification.

What special tax rules apply to metals ETFs?

Individual taxpayers who trade or invest in gold, silver or platinum bullion are subject to the IRS’ rules that govern “collectibles” for tax purposes. The same rules apply to ETFs that trade or hold gold, silver or platinum. Under the rules that apply to collectibles, if gain is short term, it is taxed as ordinary income. If gain is earned over a period that spans more than one year, then it is taxed at capital gains rates, depending on the taxpayer’s income tax bracket. This means that taxpayers cannot take advantage of the normal capital gains tax rates on investments in ETFs that invest in gold, silver or platinum. The ETF provider will specify what is considered short-term and what is considered long-term gain or loss.

What is the advantage of being able to sell an ETF short?

A short sale is a market transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares to the lender at some point in the future. The payoff to selling short is the opposite of a long position. A short seller will profit if the value of the stock declines, while the holder of a long position profits when the stock value increases. The profit that the investor receives is equal to the value of the sold borrowed shares less the cost of repurchasing the borrowed shares for repayment to the lender at a later date.

Like purchasing on margin, this is a higher risk investment strategy that, if executed properly, can produce a high profit, thus making ETFs a more attractive strategy for sophisticated investors. Mutual funds cannot be sold short.

 What is the advantage of being able to purchase ETFs on margin?

Investors who hold securities in brokerage accounts can use their portfolios as collateral for loans from the brokerage for purchasing additional securities. These loans and cash for the purchase of securities are held in accounts known as “margin accounts.” Using margin accounts effectively allows investors to use their brokerage’s cash to buy securities and leverage their gains.

The dollar amount that is currently available in a margin account for the purchase of securities or for withdrawal from the account using the portfolio as collateral is the “margin loan availability.”

The margin loan availability will change daily as the value of margin debt (which includes purchased securities) changes. If the margin loan availability amount in an investor’s account becomes negative, the investor may be due for a margin call, which is a formal request that the investor sell some of the marginable securities in order to repay the brokerage.

What is a leveraged ETF?

A leveraged ETF uses financial derivatives and debt to amplify the returns of an underlying index. Leveraged ETFs are available for most indexes, such as the Nasdaq-100 and the Dow Jones Industrial Average. These funds aim to keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio.

A leveraged ETF does not amplify the annual returns of an index; instead it follows the daily changes. For example, in the case of a leveraged fund with a 2:1 ratio, each dollar of investor capital used is matched with an additional dollar of invested debt. On a day in which the underlying index returns 1%, the fund will theoretically return 2%. The 2% return is theoretical, as management fees and transaction costs diminish the full effects of leverage.

The 2:1 ratio works in the opposite direction as well. If the index drops 1%, the fund’s loss would then be 2%.

The goal of a leveraged ETF is for future appreciation of the investments made with the borrowed capital to exceed the cost of the capital itself.

The typical holdings of a leveraged index fund would include a large amount of cash invested in short-term securities, and a smaller, but highly volatile, portfolio of derivatives. The cash is used to meet any financial obligations that arise from losses on the derivatives.

A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Most derivatives are characterized by high leverage. There are also inverse-leveraged ETFs that sell the same derivatives short. These funds profit when the index declines and take losses when the index rises.

What are currency ETFs?

Currency ETFs allow investors to invest in foreign currencies in the same manner as with stocks or any other ETF. Currency ETFs replicate the movements of the currency in the exchange market by either holding currency cash deposits in the currency being tracked, or using futures contracts on the underlying currency.

Either way, these methods should provide a highly correlated return to the actual movements of the currency over time. These funds typically have low management fees, as there is little management involved in the funds, but investors should be advised to examine the fees before purchasing.

There are several choices of currency ETFs in the marketplace, including ETFs that track individual currencies. For example, the Swiss franc is tracked by the CurrencyShares Swiss Franc Trust (NYSE:FXF). If an investor believes that the Swiss franc is set to rise against the U.S. dollar, he or she may want to purchase this ETF, while a short sell on the ETF can be placed if an investor believes that the Swiss currency is set to fall.

ETFs that track a basket of different currencies are also available. For example, the PowerShares DB U.S. Dollar Bullish (NYSE:UUP) and Bearish (NYSE:UDN) funds track the U.S. dollar up or down against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. If an investor believes that the U.S. dollar is going to fall broadly, it may be advisableto purchase the PowerShares DB U.S. Dollar Bearish ETF.

There are even more active currency strategies used in certain currency ETFs.

In general, much like other ETFs, when a currency ETF is sold, if the foreign currency has appreciated against the dollar, the sale will produce a profit. On the other hand, if the ETF’s currency or underlying index has declined relative to the dollar, a loss is generated. There is, however, a difference in how these profits are taxed. Most currency ETFs are in the form of grantor trusts. This means that the profit from the trust creates an ordinary income tax liability for the ETF shareholder based on the rules that apply to grantor trusts.

As a result, currency ETFs are not eligible for the typically favorable long-term capital gains rates, even if the ETF is held for a period of several years. Since currency ETFs trade in currency pairs, the taxing authorities assume that these trades take place over short periods.

What is a “Double Gold” ETF? How is its yield taxed?

A Double Gold ETF is an exchange-traded fund that tracks the value of gold and responds to movements in the same manner as an otherwise similar double leveraged ETF. A double gold ETF is one in which the spot value of gold or a basket of gold companies acts as the underlying asset for the fund. The ETF attempts to deliver price movements that are twice the value of the movements of the underlying gold. It is important to note that even though there is a potential for recognizing significant profits with this strategy, the risk of loss is also significant because the price could fall dramatically.

Double gold ETFs are by no means a unique fund product. There are numerous leveraged ETFs that aim to deliver movements equal to two or more times the movements of their underlying assets. Some examples include leveraged ETFs on natural gas and crude oil. These ETFs can also aim to mimic an inverse movement relative to the underlying assets; such ETFs are known as inverse or bear ETFs.

It is also important to remember that trades or investments in gold are treated as “collectibles” for tax purposes. The same applies to ETFs that trade or hold gold. As a collectible, if gain is short term, then it is taxed as ordinary income.

If gain is earned over a period spanning more than one year, then it is taxed at capital gains rates, depending on the investor’s income tax bracket. This means that investors cannot take advantage of normal capital gains tax rates on investments in ETFs that invest in gold for shorter-term investment.