Exchange-traded Funds (ETFs) have been around for about 20 years and are similar to mutual funds. Like mutual funds, ETFs are an investment structure that pools the assets of its investors and uses professional managers to invest the money to meet the investors’ objectives, such as current income or capital appreciation.
Unlike mutual funds, ETFs are traded like stocks. All the buying and selling methods available to stock investors are also available to ETF investors. These buying and selling methods include market orders, limit orders, stop orders, and buying on margin. These methods are not available for mutual fund investments.
What is an ETF?
An ETF is created when an institutional investor deposits securities into a fund in exchange for shares. Once the institutional investor acquires the ETF shares, some or all of the ETF shares may be traded and priced throughout the day on a stock exchange. Individuals do not purchase shares in an ETF directly from the fund; instead, individuals purchase ETF shares on the stock exchange in the same manner they would when they purchase stock shares.
ETFs have the following characteristics:
- no sales loads (although brokerage commissions apply)
- they can be bought and sold throughout the day; mutual funds can only be redeemed at the end of the day
- ability to buy on margin (not available for mutual funds)
- ability to sell short (not available for mutual funds)
- relatively low management fees (typically from 0.15% to 1.0%)
- instant exposure to a diversified portfolio of stocks
ETF Tax Benefit Not Available to Mutual Funds
Because of the way ETFs are structured, they offer an advantage that mutual funds do not. When mutual funds are redeemed, the mutual fund will sell securities to cover the cash paid to the investor. When this happens, the sold securities generate capital gains which are taxed to the mutual fund investors.
With ETFs, redeeming investors do not receive cash. Instead of cash, they receive the underlying securities that the ETF invests in. Therefore, the ETF does not have to sell securities to cover redemptions and there is no capital gain generated. When ETF investors want to cash out, they simply sell the ETFs shares on a stock exchange.
ETFs can invest in commodities; however, these ETFs are subject to special rules.
Precious Metal ETFs Organized as Grantor Trusts
An investment in a precious metals ETF may be treated as a direct investment in a collectible. Collectibles are subject to the higher capital gains tax rate of 28%. Additionally, collectibles generally are not allowed for IRA investments. If an IRA invests in certain precious metals, the investment will be treated as a taxable distribution (potentially subject to the 10% penalty).
Foreign Currency ETFs Organized as Grantor Trusts
Generally, foreign currency gain or loss is considered ordinary income so the favorable capital gains tax rates do not apply.
If you have questions on how this relief applies to you, give us a call at 248-538-5331.