Exchange Traded Funds. A Prudent Investment Solution

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1 Exchange Traded Funds A Prudent Investment Solution

2 Exchange Traded Funds When it comes to investing, what is better, mutual funds or exchange traded funds (ETF)? Efficient Advisors believes that as long as the mutual fund or ETF is low cost, is part of an overall diversification strategy and is not actively managed, you can build a prudent portfolio designed to deliver market returns. For investors looking for a tax efficient investing solution, ETFs may be the answer. Page 2

3 Part I. What is an Exchange Traded Fund? Believe it or not, ETFs have been around a while. ETFs were first launched in the U.S. in As of December 31, 2008, the size of the U.S. ETF industry was over $534 billion dollars. Since many ETFs invest in targeted asset classes, they are ideal for investors seeking a passive, structured strategy. Other key characteristics of ETFs: There are ETFs for major asset classes such as equities, bonds, currencies and commodities. Equity ETFs are baskets of investments that represent a diversified group of companies (similar to mutual funds). ETFs, however, trade like ordinary stocks on a stock exchange and can be bought or sold throughout the day. Some equity ETFs mirror well-known indexes like the S&P 500 or the Dow Jones Industrial Average, and some track securities specific to a particular industry or country. Page 3

4 Part II. Unique Features of ETFs ETFs by their very structure offer investors the ability to invest tax efficiently, diversify broadly and capture a capital market rate of return in a low cost efficient manner. Some notable unique features of ETFs are listed below: Compared to most active or passive mutual funds, comparable ETF expenses are lower. According to the Morningstar Principia database, the average expense ratio of mutual funds (as of May 2009) had a cost of 1.30% compared to ETF s at.55%. Though this cost difference may not seem significant, the difference on a $100,000 investment over 20 years is over $16,000. ETFs are easily accessible since they can be bought or sold like individual stocks. Instead of paying potential load fees, ETFs have brokerage cost. Page 4

5 ETFs offer better tax efficiency for investors. Perhaps no one has addressed the structure tax advantages of ETFs in a clearer or more candid way than DFA academic advisors Kenneth French and Eugene Fama: The big advantage of ETFs is that the sale of securities inside the fund does not typically generate taxable capital gains for ETF shareholders. Investors in traditional open-end funds must pay taxes each year on any net capital gains generated by trades inside the fund. As recent recipients of 1099s well know, these capital gain taxes are due regardless of whether the investor has sold any fund shares. ETFs avoid irksome capital gain distributions through the clever use of exchanges in kind trades of fund shares for securities in the fund with arbitrageurs. Because these trades are not taxable events, ETFs are typically able to rebalance their portfolios without realizing capital gains. Page 5

6 ETFs are more tax efficient than index mutual funds. Index mutual funds themselves are highly tax efficient compared to actively managed mutual funds. But they still make capital gains distributions, which means that investors who hold them in taxable accounts (as opposed to retirement accounts) will get hit with tax bills. In contrast, index ETFs generally make minimal or no capital gains distributions. The broader and more liquid the index, the smaller the capital gains. ETFs are relatively tax-efficient investments, especially when compared to actively managed mutual funds. One reason is that ETFs do not have to redeem shares for cash when you want to sell, as open-end mutual funds must do. That reduces portfolio turnover. Limiting short-term capital gains which are taxable at your regular income tax rate and eliminating what are known as phantom gains, or fund earnings on which you may owe tax but which were accrued before you purchased your shares. Large institutional shareholders who can exchange their ETF shares for the underlying securities, or vice versa, are conducting in-kind transfers, which don't produce capital gains either. Page 6

7 Better and easier tax management is possible with ETFs than index mutual funds. This is a key advantage that can result in significant financial differences, particularly for large accounts. If you buy ETFs in a brokerage account that tracks tax lots and allows you to indentify tax lots for sale, you can sell ETF s with the highest cost-basis, thereby minimizing taxable gains. (You can also make charitable gifts of appreciated stock funds with the lowest cost basis.) With index mutual funds, in contrast, your holdings are often reported - and can be sold - using average purchase price only, reducing your ability to realize tax losses (and give away appreciated stock). Page 7

8 Part III. Getting Started: Investing with Exchange Traded Funds Efficient Advisors recommends that investors work with a trusted Advisor to implement a prudent allocation strategy. A trusted Advisor ensures that you will remain prudent, unemotional and disciplined (market volatility coupled with imprudent investment behavior can potentially hurt your portfolio s performance and rob you of the needed return to sustain your financial needs). A prudent investment strategy focuses on capturing the returns of the market without the need to pick stocks, pick sectors, time the market or any other speculative investment techniques. Embrace the Prudence of Passive ETF Investing. The goal of passive investing is to achieve the market rate of return rather than trying to BEAT the market. By targeting specific asset classes (i.e., U.S. large companies, U.S. small companies, U.S. large value companies, U.S. small value companies, International companies, etc.), a prudent ETF asset class allocation strategy allows you to forgo the need to forecast or predict the direction of the market. The only action you will need to take is to rebalance the portfolio when the allocation targets are out of balance. Page 8

9 Determining the Asset Allocation. The asset allocation decision is one of the most critical decisions that you must make since the majority of investment return in your portfolio comes from the portfolio structure. Since stocks and bond behave differently, the goal of asset allocation is to maximize the portfolio s expected return in relation to it s risk. Rebalance the Portfolio. Since asset classes do not move in the same direction all the time, the asset allocation percentages will drift from its original allocation targets. It is imperative to maintain the allocation targets so you can capture the asset class returns in the portfolio. Rebalancing adheres to the simple principle of buying low and selling high. Stay the Course but Adjust if Needed. Life and all its circumstances bring unexpected events that might require us to make changes. A formalized plan can help us to determine if our plan needs course correction or adjustment. Ignore the Financial Pornography. It can be unsettling to watch the hype spouted by financial gurus, talking heads, financial news shows, etc. It is best to implement your plan, turn off the noise and enjoy your life. Page 9

10 About Efficient Advisors Efficient Advisors, LLC (Efficient) is an independent registered investment advisory and technology firm located in Philadelphia, Pennsylvania focused on supporting and enhancing the practices of financial advisors. Efficient offers discretionary asset management, back office services, integrated marketing and branding strategies all aimed at assisting financial professionals to operate efficiently and in the best interests of their clients. Page 10

11 About Lawain Mac McNeil Lawain McNeil is Chief Executive Officer and founder of Efficient Advisors. He oversees advisor training and development. As former Executive Vice President of Sales & Marketing for one of the largest independent registered investment advisory firms in the United States, Lawain brings a vast amount of experience in advisor training, education and marketing. He has consulted and coached many financial advisors on how to shift from a commission based practice to a fee only fiduciary practice. Lawain has assisted advisors in capturing over $1 billion dollars in assets under management. A lover of technology, Lawain is the creator of the Blog, AdvisorBlogger, a social media site created for financial professionals. You can visit his blog at Page 11

12 Contact Information For more information on ETFs and the efficient management of low cost, diversified ETF portfolios, please contact: Efficient Advisors 1500 Market Street Suite 3310E Philadelphia, PA Page 12

13 The Difference Between Mutual Funds & ETFs Mutual Funds ETFs Issue shares that represent ownership interest in the funds Issue shares that represent ownership interest in the funds Holds underlying basket of stocks Holds underlying basket of stocks Can be bought or sold on the stock exchange Can be bought or sold on the stock exchange Return expectations the same as a similar or like ETF Return expectations the same as a similar or like Mutual Fund Shares traded directly with the mutual fund company When buying shares monies placed directly into the fund by investor or brokerage firm-new open end mutual fund shares are created at the close of the business each day (NAV) Shares purchased directly from fund company Open end mutual funds priced once per day at the closing NAV (net asset value) Open end funds have a one-day settlement Shares purchased from other investors and sold to other investors ETFs always purchased through a brokerage firm. Shares already exist in someone else s portfolio-just like buying individual stocks Shares purchased from an AP (authorized participant) that trades directly with the fund company. These indirect shares are called creation units Priced continuously throughout the day ETF have a three day settlement Open end funds always have five letters in the symbol designator (always ending in X ETFs typically have three letters in the symbol designator Source: The ETF Book, Rick Ferri, 2009

14 The Difference Between Mutual Funds & ETFs ETF Share Creation & Redemption-How it All Works by Rick Ferri (The ETF Book) Authorized Participants (AP) are independent third party specialist and market makers that create and redeem shares on behalf of investors. There is more than one AP that covers ETFs. This levels the playing field and ensures that there is transparency in trading and selling of ETF shares. ETFs track securities indexes (an exception are actively managed ETFs which The Advisor Lab does not use). When ETF shares are created, APs buy (or borrow) the appropriate basket of stocks and exchange them for ETF shares. The individual securities and cash basket must be equal to the NAV holdings from the previous close. What is a Creation Unit? Creation Units are large block of ETF shares (usually 50k). APs can hold the unit, break it up into individual ETF shares, or trade it to another AP. The Portfolio Composition File (PCF)-after the NAV is established at the close of the market, ETFs publish a PCF listing the exact names and number of underlying securities and cash required by the AP to receive one creation unit. These PCF files are sent to the NSCC (National Securities Clearing Corporation). The NSCC processes and distributes PCFs to ALL APs before the next market day opening. If ETF shares are trading at premium to their intraday value, an AP will buy the securities that make up the fund, add cash according the PCF, and exchange that basket for a creation unit. The AP will then sell the creation unit for a market price greater than the value of the securities turned in. That generates a risk-free profit. The arbitrage trade is repeated again and again until there is no profit left for the AP. At that point the ETF market price and its NAV are probably in an acceptable range. Source: The ETF Book, Rick Ferri, 2009

15 The Difference Between Mutual Funds & ETFs If ETF shares are trading at a discount to their intraday value, an AP will sell securities that make up a fund and buy ETF shares on the market. Once the APs buy enough ETF shares to form a creation unit, or trade from their account, the will exchange that unit for its underlying cash and securities. The unit redemption covers the AP for the stocks they already sold. The price arbitrage generates a small risk-free profit to the AP, and the trades are repeated over and over until the profit incentive is gone. Source: The ETF Book, Rick Ferri, 2009

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