An exchange traded fund is a cross between stock and indexed mutual funds. You can purchase them through brokers and they are traded on exchanges just like stocks. They represent a basket of holdings that are designed to track a certain index. The underlying assets can range from stocks, bonds commodities, real estate, precious metals — the list can go on and on.
Not all ETFs are the same, and making the wrong choices can cost you significantly. Consider the following factors when you look at ETF options for investing.
Fee structures can differ. Just because it is an ETF that does not necessarily mean that you will have low fees with your investment. Expense ratios can be high, approaching that of an index fund. Sometimes, if you do not need the trading convenience, an index fund may be a better choice. The management fee isn’t the whole story either. Some ETFs have higher administrative fees than others.
Is it actively or passively managed? ETFs can be either active or passively managed. In active management, the manager trades the asset within the ETF to either meet or exceed the stated index. Passive management is managed with limited intervention.
Is there a tracking error? If you are buying an ETF to represent a certain market segment or sub-sector, it should closely match the performance of the index. If you have purchased this ETF to track a certain index and it does not track the index, something is wrong. Sometimes, active ETFs may have a greater tracking error because the manager is trying to add value above the benchmark. They may or may not succeed in this endeavor. If you are buying an ETF to simply represent the return on an index, tracking error should be minimal.
Many ETFs contain highly concentrated positions. Some even have equal weighting of the securities that it holds. The performance results may be far different than what you were seeking. You should review the holdings to make sure that the ETF is suited for your asset allocation and investment program.
Some ETFs have a higher risk profile by maintaining a certain amount of leverage. Leverage is normally kept in the form of debit or derivatives. The use of leverage will magnify the returns either for the good or bad. Be sure that you factor this type of risk into consideration when choosing an ETF.
Other higher risk ETFs are in the form of inverse ETFs. Inverse ETFs bet against the rise of a certain index so returns increase as the index return decreases.
Tax implications of ETFs may not always be straight forward. Taxes generally relate to the holdings and not the ETF itself. A gold ETF will be taxed as a collectable even though you purchase it the same as you would a stock.
Make sure that the ETF is big enough to stick around. A little-known fact is that a unitholder vote is not required to stop operating an ETF. If you have purchased a small ETF that the manager finds is not particularly profitable, you could find it closed without notice.
Clearly, there are certain things to be cognizant of when investing in ETFs. You never can have too much information.
Sharon L. Thornton is chief compliance officer/senior director of investments for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534, (585) 586-4680.