Investing – Exchange Traded Funds (ETFs)

If you read the post on mutual funds, you probably thought: wow, these seem great.  Then you got to the part about taxes and thought – whuh oh!  Imputed capital gains taxes?  Me?  Non!!  (That’s French for “no.”  I think.  I don’t speak French).

Lucky for us, there’s an alternative form of investment that provides diversification but generally tends to have less interim tax liability while you hold it.  Note the less – not zero – less.

Exchange Traded Funds, or, better known as their acronym ETFs, are relatively similar in structure to mutual funds in that they’re a collection of assets held and managed by a single fund.  Investors like you and me purchase shares of the ETF that are priced based on the value of the fund’s holdings.  

I’d recommend reading the post on mutual funds before reading about ETFs: Investing – Mutual Funds.  Much of this post compares ETFs to mutual funds, and you’ll benefit from the foundation in the post about mutual funds.  But, if you haven’t read that one yet – no sweat, you should still come out of this post with a clear understanding of how ETFs work, and then you can read the mutual fund post for comparison!

Purchasing an ETF  

Did the way I describe ETFs make them sound like a mutual fund to you?  You’re right, so far, nothing different.  So here are some of the major differences.  First, ETFs are actively traded during the day, meaning that you can place a buy or sell order and it can execute immediately, or any time during the trading session depending on what type of order you place.  Unlike a mutual fund, you don’t have to wait until the end of the day for orders to execute when a price is calculated.  Not that this matters all that much when your goal is long-term investing, but it’s certainly a relevant difference.

So, when you go to purchase an ETF, you carry out a process similar to the way you purchase a share of stock.  You can purchase either a set quantity of shares of an ETF, or, with most online brokerages, you can purchase a dollar value amount, which will translate to whatever number of shares (even if fractional) matches the dollar value at the time the order clears.  

Pretty simple, no?  The actual purchase yes, but actually deciding which ETFs to invest in is a bit more complicated.  

Index Tracking ETFs

Nowadays, there are so many ETFs to choose from, it can take you some time to figure out which ones are suitable for your investment goals.  Let’s start, then, with a discussion of the most well-known ETFs – those that track a particular exchange, such as the S&P, the NASDAQ, the Dow, etc.  For your historical pleasure, the oldest listed ETF in the U.S. is SPY, which tracks the S&P 500.  

By tracking an exchange, I mean that the funds purchase and hold a composition of shares relatively similar to the shares that make up the exchange it tracks and in the same proportion.  For example, the Dow Jones average is, as of writing, based on the movement of 30 stocks, the prices of which are weighted to calculate the average (i.e., it’s not a straight average of the 30 stocks, each one’s movement affects the Dow in proportion to its weight).  A Dow-tracking ETF will hold those same shares and in the same (or similar) balance, so that as the Dow moves, the price of the ETF moves in roughly the same proportion.

Personally, my early retirement philosophy is that ETFs that track market indices are great for long-term investing, and should be a healthy part of a FIRE-seeker’s portfolio.  I hold a number of shares in exchange-tracking ETFs, and I’ll tell you why.  If you do your research about individual investors or financial advisors or certain funds, you’ll see that an oft-touted indicator of their success is that they “beat” the market, meaning that over the selected time period, they achieved returns that exceeded the return of the overall market – typically the S&P 500 is used as the benchmark. 

Beating the market, then, is somewhat of a rare achievement.  To me, this means that obtaining returns that match the market is a pretty good result if it’s otherwise unlikely that you can do better.  ETFs that track an exchange – and do it well – will give you essentially that, a return similar to the market’s return.  If you have a healthy handful of these ETFs, using 6% or so for projecting your estimated return is not unreasonable.  Just my two cents.

Other ETFs

For those who want something broader than index trackers, there are ETFs that track all sorts of things.  There are market-sector ETFs that track specific markets (think tech, utilities, consumer products, travel, etc.), commodities ETFs, country ETFs, and so on.  And like mutual funds, most are offered with no commission through the major online brokerages.  Another path toward diversification is to hold ETFs in a number of different market sectors (again though, if your goal is matching the market, there’s an easier way to do it – see above).  You can also find ETFs with specific goals like high dividends, or steady growth, or low volatility, etc.  Just do your research and you should be able to find something that suits your risk tolerance.  

Most of what I’ve mentioned above is about stock ETFs, though these are not the only options.  There are ETFs that track all sorts of assets, including, for example, bonds.  Bond ETFs are an interesting concept to me.  Bond ETFs, unlike holding individual bonds, trade based on the market prices of the bonds themselves, meaning that they’re not relying on the relative safety of bonds to pay out the face value at a specified time, but rather the movement of the bond price on the open market (although those factors are not unrelated).  Bond ETFs may also pay out interest payments received from the underlying bonds.  Just another option for a diversified portfolio.

Comparison to Mutual Funds

I wouldn’t hold it against you if you said that ETFs still sound like mutual funds, because, in many ways, they possess the same characteristics.  But there are some important differences of which you should be aware in determining whether to invest in one over the other.  

Fees – the bane of mutual funds.  ETFs still have management fees – someone has to pay to keep the cubicles pristine at the brokerage houses.  ETFs, however, tend to be less actively managed than mutual funds.  Once the initial allocation is determined and the shares acquired, there’s less to do unless the underlying collection of securities changes.  This is particularly so for the ETFs that track the major indices, none of which change their composition and weighting all that often.  And when they do, there’s less to figure out because it’s clear exactly what changed – it’s no secret when the Dow drops a stock or changes its weighting; in fact, you’ll probably read about it in the news.  And you’ll probably see 217 articles on what it means for investors.  So it’s relatively simple for the fund managers to execute transactions to reflect adjustments to the index.

Industry-based ETFs will have a little more management because companies are always fluctuating and their fortunes changing, compelling fund managers to alter their holdings when it might be necessary to capture gains or head off some major losses.  But overall, ETFs tend to have lower management fees than mutual funds – it’s all right there in the disclosures.  Speaking of which, ETFs, like mutual funds, provide heaps of information for your reading pleasure, and it may certainly behoove you to take a glance to determine what you’re purchasing.

Taxes

And then there’s taxes, right?  

First, the obvious – you’ll incur capital gains taxes when you sell shares of an ETF: long-term if held more than a year, short-term if one year or less.  

Now, the less obvious.  Like mutual funds, as the holder of an ETF, you are technically the owner of a proportionate share of the underlying securities held by the ETF.  However, unlike mutual funds, ETFs generally have fewer – if any – taxable events that result in capital gains at times other than when you sell shares of an ETF due to special structuring allowed by the IRS.  That is, unlike with mutual funds, ETFs tend not to distribute “phantom” or “imputed” income to shareholders that result in capital gains taxes even when no cash is received.

The reason for the difference is that while mutual funds have to buy and sell securities to generate money when holders of the funds redeem their shares (i.e., they want out), ETFs pay off old and receive new investments through “in-kind” transactions, rather than share sales.  Sound complicated?  It is, so don’t worry too much about the details.  The point is that ETFs generate fewer, if any, interim capital gains (and phantom income) than mutual funds.  ETFs that track an index rarely incur capital gains while you hold the ETF (but of course, you may still incur a capital gain if you sell your interest at a higher price than you bought it).

ETFs do distribute dividends paid by the underlying securities, which are then taxable to you, the holder of the ETF, at the applicable tax rate.  Dividends are taxed at different rates based on how long the ETF holds the asset that is paying the dividend and how long you hold shares of the ETF. 

“Qualified” dividends are dividends paid on stocks that the ETF held for greater than 60 days, and are eligible to be taxed at your capital-gains rate, while “nonqualified” dividends are those held by the ETF for 60 days or fewer, and are taxed to you as ordinary income.  Note, however, that if the ETF holds the underlying asset for greater than 60 days, the dividend only becomes eligible to be a qualified dividend.  You must also hold the ETF for more than 60 days to take advantage of this; if you hold the ETF for 60 days or fewer, any dividends, regardless of how long the ETF held them, will generally be treated as ordinary income to you.

There are some exceptions to ETF taxation that I’ll briefly mention that only apply when you invest in certain types of ETFs, and generally do not include the major index trackers.  International ETFs – that is, ETFs that trade outside the US and/or hold equities of companies from non-US exchanges, may not always qualify for the “in-kind” type of redemption, meaning that they may generate interim taxable events that are passed along to you.  Certain other types of ETFs, like commodities and highly leveraged ETFs, may also be subject to different rules.  These types of investments tend to fall on the riskier side and are the type I stay away from, if for nothing more than I don’t have the risk tolerance or patience to understand how they work.  If you’re looking into these, be sure to check how you might wind up paying taxes while you hold them.

Overall, I like ETFs, as do most people I know that invest casually and on a longer-term horizon.  They trade like stocks but offer greater diversification, and because they’re taxed similar to stocks – capital gains only when sold with dividends in the interim – they’re a little easier to manage.  And like I said earlier, index-tracking ETFs are a great way to (almost) replicate the returns of the overall market.  The more I hold in index-tracking ETFs, the more confident I feel about my projections of future income, a critical aspect of obtaining enough security to retire without having to worry about whether I’ll run out of money before I, uh, stop needing it.