What’s unique about ETFs?

While ETFs are similar to index mutual funds in some ways, there are also some important differences between the two. Most of these arise from their distinctive creation and redemption process:

No cash drag: Because ETFs don’t have to redeem shares, they have no need to allocate a portion of their portfolios to cash. This helps limit the potential for cash drag, or a reduction in a fund’s performance caused by cash allocation.

Trading flexibility: ETFs trade like stocks, opening the door for a variety of trading techniques that aren’t available with mutual funds. For instance, active traders may buy on margin, sell short, and use stop and limit orders. Whereas mutual fund prices are set daily at the close of trading, ETF prices fluctuate throughout the trading day. The purchase price for an ETF can be at a premium or discount from the Net Asset Value (NAV), based on supply and demand in the marketplace.

Additionally, buyers and sellers of ETFs must cover a portion of the “bid/ask spread” — the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. ETF transactions are typically conducted in the middle of the spread, meaning that, in effect, you pay half of the spread at the time you buy and half when you sell. That spread is the profit that the broker or market maker realizes on the trade.

Tax efficiency: ETFs don't have to buy and sell shares to accommodate shareholder purchases and redemptions as mutual funds do, minimizing portfolio turnover and the potential tax consequences of capital gains or losses.

And ETF managers have an additional tool for reducing taxes. That’s because the only way to redeem shares is to have an authorized participant exchange them for a basket of the securities tracked by the ETF. That’s the reverse of the way in which the shares are created.

This exchange is an in-kind trade, not a taxable transaction. In addition, the ETF is able to hand over the securities with the lowest cost basis — those that cost the fund the least to acquire. This effectively steps up the basis of the ETF’s remaining securities, reducing the potential capital gains taxes that might be triggered when the portfolio is updated to reflect a change in the composition of the underlying index.

However, while these tax savings are characteristic of large, frequently traded ETFs that track major indexes, they may not be as available with others that are more thinly traded or that are based on indexes whose composition may change frequently.

Investing in an ETF within your tax-deferred retirement account limits the tax-efficiency benefits of the investment. However, ETFs may still be useful in your 401(k) or traditional IRA portfolio because they can be valuable asset allocation and diversification tools.

BACK