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?