Exchange Traded Funds, more commonly known as ETFs, are one of the most frequently traded types of securities in the market. Practically everyone with an investment account owns them, and you might have heard the term here and there. But what exactly are ETFs, how do they work, and what benefits do they provide investors?

During a recent Top of Mind with Consilio Weath podcast episode, we demystified the ETF and dove into some of the tax efficiencies around ETFs. Here are some of the highlights of that episode, including how these securities work, common types you’ll find on the market, and ETF strategies to maximize your return.

What is an ETF?

An exchange-traded fund is similar to a mutual fund in that it’s a type of pooled investment security. ETFs are typically passively managed and track a given index or sector. However, that’s not a requirement – some types of ETFs are actively managed, but they aren’t as common. 

One way ETFs and mutual funds differ is that ETFs can be purchased or sold through an exchange during the trading day (just like a stock). ETFs also don’t have minimum opening deposit requirements. With the advent of fractional shares, many investors can get started investing in ETFs for less than $10. 

ETF Tax Efficiencies 

Although ETFs share many similarities with mutual funds, there’s another key area where ETFs differ from mutual funds: tax treatment. 

Capital Gains

ETFs are often a much more tax-efficient way to invest your money, simply due to the way ownership is distributed. 

With a mutual fund, your money is pooled with other investors' money and then invested. The collective value impacts every investor in the fund – so if one individual chooses to sell, the fund manager will have to buy and sell underlying holdings to rebalance the fund. This affects everyone else in the mutual fund and can hit investors with capital gains distributions, even if they are brand new to the fund. 

Whenever you purchase an ETF, you are purchasing your own individual “slices” of a pool of individual companies. You’ll own and retain these shares separately from other investors in the ETF. Your shares won’t be sold unless you sell your shares of the ETF. Likewise, if someone else sells, it generally won’t affect your own holdings or capital gains responsibilities. Quick disclaimer, some ETFs have paid capital gains distributions, but it’s rare. 

Creation and Redemption

As individually packaged funds, ETFs can benefit from a process called creation and redemption. New ETF shares can be created or redeemed by exchanging securities in an “in-kind” transfer, meaning the same securities with the same value. 

This mechanism is a nontaxable event. Nothing is technically being bought or sold within the fund – simply created or redeemed within the fund. 

Types of ETFs

There are tons of ETF types out there, with more names being launched every day. Each has its own benefits and drawbacks, and some will be better suited for you than others. 

Some of the most common ETF types include:

• Index Funds - These ETFs track an underlying index or stock market benchmark, like the S&P 500, Nasdaq 100, Dow 30, or Russell 2000.

• Active ETFs - Similar to mutual funds, someone behind the scenes is actively making trades in an attempt to beat the index or benchmark they’re assigned to. 

• Sector Funds - This type of ETF focuses on purchasing specific companies that operate within a given industry, such as real estate, retail, or pharmaceuticals.

• Factor ETFs - These ETFs use underlying mathematical factors, such as growth, value, dividend growth, or momentum. 

• Leveraged ETFs - Compared to traditional ETFs, these come with much higher risk. Leveraged ETFs use options contracts to lever up their positions, leading to heightened volatility and price swings. Leveraged ETFs often come with higher internal fees as well. Disclaimer, in general, you shouldn’t buy there. They are designed for day trading and momentum trading, two things you probably shouldn’t do.

• Inverse ETFs - Much like leveraged ETFs, inverse ETFs are a risky investment vehicle. These ETFs use complex derivatives to achieve inverse returns. For instance, when the S&P 500 declines in value by 1% in a day, an inverse S&P 500 ETF would appreciate by roughly 1%. Given the complexity of these ETFs, they typically involve higher fees. 

• Disruptive ETFs - This misleadingly-named fund focuses on a certain type of company or investment style. Unfortunately, though, the marketing style doesn’t always match the investment style used by the fund managers. The most common company that these focus on is cash burning small, unprofitable tech companies. What sounds better, that last sentence or replace all that with the word disruptive. 

Any time you look into ETF investments, be sure to practice due diligence and research specific funds. ETF names can often be a marketing tactic to encourage you to buy one fund over another, and the name of the fund is not necessarily indicative of what the fund actually owns. After all, who wouldn’t want a fund that implies “growth” or “value”? We talk about this more on Episode 12 of Top of Mind with Consilio Weath.

ETF Investing Strategies

There are quite a few ways that you can invest using index funds. Probably the most well known is dollar cost averaging.

Dollar Cost Averaging

Dollar-cost averaging is perhaps one of the most commonly employed ETF investing strategies, you’re likely already doing this! 

Dollar-cost averaging involves deploying capital at a steady, recurring rate into a given investment, regardless of recent price performance. Making consistent investments allows investors to lower their cost basis during market dips, leading to higher returns in the long run.

For instance, many people dollar-cost average into the funds within their 401(k) plan. The same amount of money is invested into given funds or ETFs each and every pay period. 

Invest With Confidence

Although ETFs are a great way to diversify your investments, an investment plan is not a financial plan. And financial planning is an ongoing and dynamic approach to someone's unique and changing situation. ETFs and financial plans are not one size fits all. Consilio Wealth Advisors specializes in crafting financial plans to help tech professionals grow their personal wealth and achieve financial independence. With collective decades of experience, our team of dedicated professionals is here to help you assemble a strategy to reduce your tax burden while putting your assets to work for you. 

If you want to learn more about what Consilio Wealth Advisors can do for you, schedule a call or fill out our contact form, and one of our trusted advisors will be in touch with you soon!

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The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

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The information contained above is for illustrative purposes only.

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