Exchange Traded Funds

Exchange Traded Funds (ETF’s) are similar to index Mutual Funds. One of the most common ETF structures is as follows. A trust is set up. The trust buys all of the stocks in an index in the same proportion as the index. The trust issues Depository Trust Receipts (DTR’s), which are like shares. These DTR’s are usually issued for a fraction of the index value like one tenth.

The Depository Trust Receipts are traded on a stock exchange like the American Stock Exchange. The price of the DTR goes up and down exactly in step with the index. Unlike Mutual Funds, the price of ETF’s are set with every trade instead of the end-of-day Net Asset Value. So ETF’s are more liquid than Mutual Funds. Also, when an investor wants to buy or sell an ETF, the does so with another investor through the exchange. The transaction does not affect the securities in the trust. This improves the tax efficiency of ETF’s even compared to index Mutual Funds.

Let me explain. When you sell your shares of a mutual fund, the fund manager has to sell some of the stocks in the fund to get the money to pay you. This triggers a capital gain or loss for the fund. Investors who did not sell, have to pay taxes on the gain at year end, even though they did nothing to create a tax liability. So they end up with an unexpected and undesired tax. With an ETF, because you are not trading with the Trust, but with another investor, the trustee does not have to sell stocks from the trust to create enough liquidity to pay you. So there are fewer year end surprises. The only buys and sells in the trust are for companies that enter or leave the index the trust is replicating. There are other ETF structures, but they all have similar advantages.

Like index Mutual Funds, ETF’s are Beta investments. They do not have active management. As a result, most ETF’s are inexpensive, often charging slightly less than index Mutual Funds for the same indexes.

ETF’s have been growing rapidly since about the year 2000. Today there are dozens of different indexes available. To prevent a conflict of interest with the firm I work with, I do all of my personal investing in ETF’s.

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