What is an ETF?
ETFs don't try to "beat" the market, they try to "be" the market.
In the simplest terms, exchange traded funds (ETFs) are funds that attempt to replicate the performance of a particular index instead of outperforming it, like a mutual fund. Meaning, ETFs don’t try to “beat” the market, they try to “be” the market.
When you buy a share of an ETF, it represents a portion of all of the fund’s underlying investments. This enables you to diversify across a predetermined basket of stocks or bonds through one single fund—providing access to the stock or bond market without having to make individual purchases.
Most ETFs function like an index fund. For example, if you were to purchase an S&P 500 Index ETF, that ETF would own all 500 stocks listed in the S&P 500 Index.1 It will not trade in and out of those stocks. It will simply own the stocks listed in that index. By buying a share of the ETF, your money is instantly diversified across all of the underlying securities.
Creating a Diversified Portfolio
ETFs help build a diversified, more efficient portfolio.
When it comes to investing, you have a wide array of options to choose from to help you meet your financial objectives—stocks, bonds, and mutual funds being some of the most familiar. ETFs have become an increasingly popular option, and are advantageous in helping an investor build a diversified, more efficient portfolio.
- Increased access to a wide variety of investments The ETF market has dramatically expanded since the first one was introduced in 1993. The rapid growth of this market has provided investors with access to a wider variety of investments.
- Designed to enhance portfolio construction ETFs can be used to provide low cost, transparent exposure to various asset classes, regions, sectors, or investment styles as core investments, complementary investments, or supplemental investments.
- Flexibility to take advantage of market opportunities Traded throughout the day like traditional stocks and bonds, ETFs provide a high level of liquidity and increased flexibility to take advantage of market movements.
- Lower expenses and tax consequences Expenses and taxes can greatly reduce an investor’s return over time. ETFs typically have lower expenses and tax consequences, making them attractive to many investors.
Types of ETFs
Discover the different types of ETFs.
The ETF market includes both broad markets and specific sectors and countries. The majority of funds within the ETF market can be categorized into the following types:
|Type of ETF|
|Tracks a particular equity index.|
|Provides exposure to a universe of bonds being tracked by the market (i.e., high-yield bonds, municipal bonds, and Treasurys).|
|Sector and Industry ETF|
|Provides exposure to a specific industry.|
|Tracks the price of a certain commodity.|
|Tracks a market capitalization focus or investment style.|
|Foreign Market ETF|
|Tracks markets outside of the U.S.|
|Designed to profit from a decline in the value of an underlying benchmark by holding various short positions, or using a combination of advanced investment strategies to profit from falling prices.|
|Alternative Investment ETF|
|Implements a nontraditional asset class or investment approach that can help manage volatility during times of uncertainty for traditional asset classes.|
|Passively Managed ETFs|
|Passive ETFs are designed to closely track the performance of a particular index. This type of investment offers investors the closest thing to investing in an index by providing direct access to the underlying securities making up that index. This passive investment approach also helps contribute to relatively low fees.|
|Actively Managed ETFs|
|Active ETFs are relatively new and have become increasingly popular in recent years as investors have embraced these vehicles as a means of combining the talents of experienced and professional management teams with the benefits of the exchange traded structure. Unlike traditional passive ETFs, which are designed to track an index, actively managed ETFs permit the fund manager to make more active decisions regarding security selection in an attempt to outperform the index. Active ETFs are generally more expensive than passive ETFs, since the overhead and expenses required to run an active ETF are greater.|
What Do ETFs Provide?
ETFs are designed to increased diversification through broader access.
ETFs can be used to provide low cost2, transparent exposure to various asset classes, regions, sectors, or investment styles as:
- Core investments to create the foundation of a portfolio in the process of being constructed,
- Complementary investments to help enhance the overall portfolio diversification of an existing portfolio, or
- Supplemental investments to help manage risk.
Gain access to all markets by combining ETFs and mutual funds Combining ETFs and mutual funds within a portfolio can provide the flexibility needed to gain complete and total access to the financial markets.Flexibility of Choice and Enhanced Diversification Diversification does not ensure a profit or protect against a loss in a declining market.
Differences Between ETFs and Mutual Funds
While similar in many ways, there are a number of differences.
While ETFs and mutual funds are similar in many ways, there are also a number of differences. ETFs differ from mutual funds in the way they are priced and in the way they trade. They are priced and traded like stocks throughout the day and their share price is driven by the value of the underlying basket of individual securities. Also, ETFs are listed on a national securities exchange—such as the New York Stock Exchange—and are typically traded through a brokerage account.
Like mutual funds, ETFs charge a management fee that is deducted directly from the assets of the fund. With ETFs, a broker’s commission fee is also assessed each time an investor buys and sells shares.
ETF investors can see exactly what they own on a daily basis, helping them minimize overlap between sectors and individual securities that they own, creating greater overall portfolio diversification.
|Similarities and Differences between ETFs and Mutual Funds|
|Priced, bought, and sold throughout the day*||•|
|Offer investment diversification||•||•|
|Minimum investment requirements||•|
|Managed by investment professionals||•||•|
|Active and passively managed options||•||•|
|Occasional fees or commissions required with a trade||•||•|
|Ability to make or lose money||•||•|
|Sell individual shares directly to, or redeem from, retail investors||•|
|Options available on the ETF or mutual fund||•|
What is an Authorized Participant?
And why are they so important to the process?
An authorized participant is someone with significant buying power, since it is the authorized participant’s job to acquire all of the securities an ETF wants to hold. For instance, if an ETF is designed to track the S&P 500 Index, the authorized participant needs to buy shares in all the S&P 500 companies in the exact same weights as the Index, then deliver those individual shares to the ETF provider.
In exchange, the ETF provider gives the authorized participant a block of equally-valued bundled ETF shares, called a “creation unit.” Creation units are usually formed in blocks of 50,000 ETF shares. In this instance, both parties benefit from the transaction. The ETF provider gets the stocks it needs to bundle into ETF shares and track the Index, and the authorized participant gets an equivalent value of ETF shares to trade on the open market.
The process can also work in reverse. An authorized participant can remove ETF shares from the market by purchasing enough of those ETF shares to form a creation unit, and then deliver that creation unit to the ETF issuer in exchange for the same value in the underlying securities of the respective ETF.Creating and Redeeming Shares Helps Maintain a Flexible Supply and ETF Price Consistency
ETFs: Lower Expenses and Tax Consequences
Your investments work harder for you instead of someone else.
Lower Expenses Operating expenses are incurred by all managed funds, regardless of the structure. However, ETF operating expenses are more streamlined compared to others. These lower costs are the result of:
- Reduced fund administration costs. When a cost can be passed on to another entity, such as the brokerage firm holding a customer’s ETFs in one of their accounts, a client service-related expense such as this helps keep costs down at the fund level.
- Reduced administrative, service, and record keeping costs. Since it is the brokerage firm’s responsibility to issue monthly statements, annual tax reports, quarterly reports, and 1099s to its clients, ETF companies benefit from the lower overhead—and part of that savings is passed on to individual investors in the form of lower fund expenses.
- Absence of redemption fees. Shareholders in ETFs avoid the short-term redemption fees that are charged on some other managed funds.2
Tax Consequences ETFs are structured for tax efficiency. With regard to capital gains taxes, they tend to be lower than other managed funds since trading/turnover within the ETF itself is relatively low. Additionally, investors only realize any potential capital gains when they sell the ETF itself.
Where dividends are concerned, the tax situation differs depending on whether the dividend being issued by the ETF is considered qualified or unqualified. For a dividend to be considered qualified, the ETF needs to be held by an investor for at least 60 days prior to the dividend payout date. The tax rate for qualified dividends then varies between 5%–15%, depending on the investor’s income tax rate. For unqualified dividends, investors are simply taxed at their current income tax rate.
1. The S&P 500 Index is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe.
2. Like mutual funds, ETFs charge a management fee that is deducted directly from the assets of the fund. Therefore, the investment return of an ETF may be lower than the underlying benchmark index. This fee may be referred to in the prospectus as an “expense ratio,” management fee,” or “investor fee.” A broker’s commission fee is also assessed each time an investor purchases shares in an ETF. It’s important to note that while ETFs do not have some of the administrative costs as similar index mutual funds, they do not always have lower fees.
This material is general in nature and provided solely for educational and informational purposes. It is not meant to provide tax advice. To obtain tax advice on ETFs, consult with your own tax advisor.
All ETFs are subject to market risk, including possible loss of principal. ETF shareholders are subject to risks similar to other pooled investments, such as mutual funds. In addition to general market risks associated with investing in stocks and bonds, there are risks specific to each ETF, which are described in its prospectus. For example, the value of securities held by the ETF may decline. ETFs that hold international investments may involve risk of capital loss from unfavorable fluctuations in currency exchange rates, differences in generally accepted accounting principles, or economic or political instability in other nations. ETFs that invest in the bond market could be hurt by rising interest rates (bond prices and interest rates move in opposite directions).
Alternative investments are speculative, not suitable for all clients, and intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment.
Fixed-income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuers ability to make such payments will cause the price of that bond to decline.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services.
Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302.