Just what is an ETF?
In the last 15 years, there has been an upsurge in the amount of exchange traded funds (ETFs) available in the market. ETFs are intended to be specialized financial instruments that mimic a specific index, or specific array of stocks, or other assets. This is why you see the creation of very specific ETFs such as a crude oil ETF or copper ETF. Some leading experts in financial markets think that ETFs’ attributes make them a very practical choice instead of trading futures or investing in annuities or structured settlements for investors seeking to increase or decrease their market exposure to different countries, sectors, or industries. It is true that ETFs give investors access to increased flexibility in terms of ease of use for a variety of applications. This can be a very attractive attribute to both institutional investors and individual investors.
One leading attribute that ETFs that makes them different from mutual fund counterparts is their tax characteristics. ETFs are considered by experts in the field to be a very tax efficient investment vehicle because shares do not need to be sold to fund cash redemptions. How can ETFs do this? ETF shares are created and redeemed via in-kind share contributions and redemptions. Thus, they are tax free for the ETF.
A study completed by experts in the field sought to compare the pre-tax and after-tax returns on the Standard & Poor’ Depository receipts (SPDRs) ETF and the Vanguard index 500 fund. Both the SPDR and Vanguard Index 500 fund are considered to be fairly established and around a long time. The results of this study indicated that between the years 1994 and 2000, the before-tax and after-tax returns on the SPDR ETFs and the Vanguard 500 index fund were similar. These results suggest that ETFs can offer investors a great method to invest that is also smart on taxes. In addition, it allows investors a method to hold a broad array of stocks while getting comparable results to a very low cost index fund.
Some people believe that the transaction costs are a limiting factor for the small investor, but the in-kind creation and redemption process provides the institutional investor the greatest tax benefit. Others disagree.
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