Exchange Traded Funds
ETFs are mutual funds that trade in the stock market; you invest in them by buying shares through a broker.
That means they're convenient if you already have a brokerage account;
the obvious drawback is that you have to pay a brokerage fee when you buy or sell shares.
One advantage of ETFs is that they have the potential to be more tax efficient than regular index funds.
Here's one example of how well that can work.
This table shows the average capital gains distributions from S&P 500 index funds, compared with the distributions from SPY, the original ETF "spider" that tracks the S&P 500:
| |
Capital Gains Distributions (percent) |
| Year |
Ave. S&P 500
Index Fund |
SPY |
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
|
1.10
1.35
3.85
2.10
2.34
1.67
1.52
2.58
1.76
0.42
|
0.00
0.00
0.00
0.12
0.00
0.00
0.00
0.00
0.00
0.00
|
Source: Unconventional Success chapter 11
Obviously, SPY provided a tax advantage over the traditional index funds.
Bad News on Taxes
Now for the bad news.
First of all, the tax advantage is coming from what feels like a loophole
(the ETF manager can magically increase the cost basis of the portfolio's holdings by exchanging shares with an arbitrageur)
and loopholes can always be closed - especially this one, since it has traditional fund managers crying foul.
But even under the current arrangement,
notice from the example that ETFs do in fact have to make capital gains distributions occasionally, even an ETF like SPY that tracks a low turnover index like the S&P 500.
So if you get interested in an ETF that tracks a high turnover index, you shouldn't expect that it will be tax-efficient, just because it's an ETF.
(For more, see this Morningstar article, Are ETFs Really More Tax-Efficient Than Mutual Funds?)
ETF Choices
If you follow the financial news you'll hear a lot about the wrong kind of ETFs:
faddish, gimmicky, high-turnover products marketed to active stock traders who don't have a plan.
But there are also many ETFs that can play a logical role within a well-designed portfolio.
See the tiny list for a few of these; also see the websites of
Vanguard (their ETFs used to be called "vipers")
and iShares.
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