More Popular Than Ever

Almost two decades since ETFs were first introduced in the U.S. and they are more popular than ever. With tax advantages, diversification potential but more error, is this vehicle right for you?

Exchange Traded Funds (ETFs) were introduced in the U.S. in 1993 and since then have steadily grown in popularity. In fact, ETFs have enjoyed a record $1.3 trillion in net asset inflows through the third quarter of 2012, according to the ETF Industry Association.

Are these investments suitable for your portfolio? Here’s a review of some ETF basics.

Vehicle type

ETFs are investment vehicles that are a lot like mutual funds but trade like stocks. Both ETFs and mutual funds provide instant diversification by owning a large number of individual securities.

Like a passively managed mutual fund, ETFs are generally designed to track the performance of specific underlying indexes, such as the S&P 500 Stock Index or the Barclay’s Capital Aggregate Bond Index. Like stocks, ETFs can be traded throughout the day, be bought on margin and sold short. Mutual funds only trade once per day at the market’s close.

Tax advantage

The large supply of ETFs in the marketplace from competing sources presents a potential tax advantage. For example, there are several ETFs that track health care industry equity indexes. If the one you currently hold in your portfolio falls below its cost basis, you may be able to sell it, harvest the tax loss, buy the equivalent ETF and not change your sector exposure at all — all without infringing on the IRS’s “wash sale” rules. Your financial advisor can provide counsel.

Diversification

ETFs can also provide an efficient way to achieve proper diversification in portfolios of any size. They are also useful in rebalancing trades to keep a portfolio true to its desired asset allocation — even the largest portfolios.

Advantage over mutual funds

With respect to tax efficiency, ETFs have a clear advantage over mutual funds. When shareholders of a conventional mutual fund sell their shares, any capital gains resulting from the fund’s sale of underlying holdings (to raise cash to honor the redemptions) are distributed to the fund’s remaining shareholders, who are tax-liable in the year of the distribution. This typically does not occur with ETFs. Investors realize capital gains or losses only when they sell their own ETF shares, and they can thus beneficially time the tax impact, or defer it indefinitely.

More error

ETFs are generally subject to more tracking error than mutual funds. An ETF share’s net asset value (NAV) is derived from the aggregate value of the underlying securities held by the ETF in essentially the same way NAV is determined for an open-end mutual fund. However, the share’s actual market value is based on supply and demand of the shares themselves, and can trade at greater or less than its NAV at any point during the trading day.

Right for you?

All told, ETFs have several important benefits that may be right for you. Be sure, however, to consult your financial advisor for guidance that pertains to your particular situation.

Matthew DiQuollo, CFP, is a financial analyst at Brinton Eaton, an SEC-registered investment advisory firm based in Madison, N.J. He can be reached at (973) 984-3352. For more information, go to www.brintoneaton.com.