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Index funds are types of mutual funds that are pegged to an index, such as the S&P 500®. These funds are not actively managed, like most mutual funds, but simply depend on the up and down movement of the index as a whole. Investing in an index fund enables investors to buy shares in an entire index in a single transaction instead of buying the individual stocks that comprise it. Best of all, index funds sometimes outperform actively managed mutual funds.
But there's one problem. Like all mutual funds, index funds are priced only once at the end of every trading day. And prices can change radically in a day, especially in turbulent markets.
Enter exchange-traded funds. ETFs, as they are called, are designed to track a specific index and therefore, may fill the role of a small-cap, mid-cap, large-cap, or international asset allocation. And ETFs let index investors take advantage of daily price movements. ETFs work just like index mutual funds, but trade like individual stocks. You can even buy them on margin and sell them short.
Exchange-traded funds have been around almost as long as index funds, and initially were the domain of institutional investors. However, they have become widely used by individuals , as those investors gained experience with ETFs.
ETFs invest in a gamut of indexes from the broad to the specialized. Standard and Poor's Deposit Receipts (SPDRs or "Spiders") follow the S&P 500 and DIAMONDS track the 30 stocks in the Dow Jones Industrial Average. Other ETFs focus on niche areas ranging from telecommunications to emerging markets to real estate. And new ETFs are popping up all the time.
Exchange-traded funds are attractive for other reasons as well: they're generally inexpensive and tax efficient. Index funds already have lower management fees than most mutual funds, but ETFs have even lower annual expenses.
At any particular time, market demand is the driver for an ETF's price. Unlike index funds, which trade at net asset value (NAV), plus any sales charge, exchange-traded funds are bought and sold at market price. ETFs typically trade at premium or discounted prices, depending on demand and other factors, much like shares of an individual stock. These stock-like features allow ETF investors to sell short, use a stop-loss order, use a limit order, or buy on margin. Mutual funds do not offer those features.
In addition to the above, ETF investors get a capital gains tax break that they can't get from mutual funds. Traditional funds can end up generating year-end capital gains even if the investor didn't sell shares. These funds must distribute capital gains that exceed losses to shareholders each year. But ETFs generate fewer capital gains because managers do not have to liquidate stock for redemptions. ETFs are preferred over mutual funds when the market turns sour, because mutual funds will likely be selling shares and incurring capital gains. On the other hand, ETF investors owe capital gains taxes only when they sell the investment.
Exchange-traded funds aren't for everyone, however. You need to properly assess how you plan to use an ETF before purchasing one. For some investors, ETFs could end up costing you more than a traditional index fund.
Keep in mind that while index funds are purchased through a fund company, you will need to buy ETFs through a broker and pay a commission. If you make regular contributions to the fund, you could rack up some hefty commission fees. And remember that if you already have a traditional index fund, you will generate capital gains taxes if you sell existing shares and move the money into an ETF. In this case, it might make more sense to hang onto what you've got and start a new investment in an ETF.
S&P 500 and SPDR are registered trademarks of Standard and Poor's Corporation, a division of The McGraw-Hill Companies, Inc.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.