ETFs are a popular investment option for both individual investors and financial advisors serving their client’s investment needs.

What is an ETF?

ETFs are baskets of stocks, bonds or other investment vehicles with similarities to both individual stocks and mutual funds. Like a mutual fund, the underlying holdings of the ETF are owned under the fund umbrella.

 ETFs trade during the period that the stock market is open, just like shares of an individual stock. Mutual funds are priced at the end of each trading day. This is the price you buy or sell it for if a trade is placed prior to the end of trading day.

Here are 6 things you may not know about ETFs:

1. You'll Have to Think About Liquidity Differently 

Normally when investors think about the liquidity of an investment they look at things like trading volume. While this is important, it is the liquidity of the ETF’s underlying holdings that really matters.

2. Trading ETFs Involves Commissions

Trading ETFs involves commissions just like trading shares of an individual stock. There is a wide range of transaction costs among major custodians. Some custodians like Schwab and Fidelity offer free trades on certain ETFs, as does Vanguard on their own ETFs.

For those who do not trade often or are making large purchases, transaction costs should not be a major factor in your investment decisions, as long they are reasonable.

3. There Are Differences in Index ETFs

There are two approaches to indexing among ETFs. Replication means the ETF attempts to fully replicate the holdings in the index. This is common for ETFs tracking large, liquid indexes like the S&P 500 and Russell 1000.

Sampling or optimization is more common with less liquid indexes. An example occurred with two popular emerging markets index ETFs. One used full replication and the other used a sampling approach. The return difference was significant, over a calendar year time period the performance difference has been over 400 basis points.

4. ETF Trading Times Will Affect How You Place ETF Orders

For U.S. based investors, ETFs trade during the trading day from 9:30 a.m. to 4:00 p.m. weekdays. This includes U.S. domiciled international ETFs. This means international markets might be closed but their ETFs are open and traded in the U.S. If the underlying positions are not trading but you are purchasing the ETF with them in it, you may be getting a less favorable execution price. Be aware of the open markets when trading international ETFs.

Settlement options differ for ETFs and mutual funds. Settlement refers to how soon your money is available for withdrawal from your account. ETFs trade T+3, meaning that the cash from a sale is available for withdrawal the third trading day after the transaction. Most major custodians will allow you to use the funds to purchase other investments in your account immediately.

Mutual funds settle on a T+1 schedule. This means trades placed before the market close will be available for use the following business day.

5. Contango Can Occur with Commodity ETFs

Commodities are an alternative asset class that can add a level of diversification to a portfolio. When it comes to investing in the price of a commodity, you may be buying a futures contract or a derivative, not the physical commodity itself.

This can lead to a condition called Contango, which is common with oil-related ETFs. This occurs when there is a wide discrepancy between a higher price of oil futures and a lower actual price of oil. ETF investors can suffer large losses when Contango occurs, even if their investment thesis is correct.

6. ETFs Can't Be Purchased in Fractional Shares

ETFs must be purchased in whole shares, unlike mutual funds. This works the same with individual stocks. This isn’t a major issue for most investors, but something to consider when making investment decisions.

Some other things to know about ETFs

ETFs are a low cost, tax-efficient way to invest in major indexes like the S&P 500. The advent of smart beta ETFs allows investors to fine-tune their strategies based on “slices” of traditional indexes focusing on factors like value, high quality, dividends and others.

ETNs or exchange-traded notes are different than ETFs. ETNs entail debt and potential exposure to credit risk. You need to understand what you are investing in and if that investment product is right for you.

Leveraged ETFs magnify the impact, long or short, of index ETFs, such as the S&P 500, by two or three times in some cases. Leveraged ETFs can be a great tool in the hands of professionals. They are very complex and we feel that individuals should avoid them and the risks they entail.

How we can help

We utilize ETFs and other investments in serving our client’s investment needs. We perform due diligence on ETFs and have a good handle on how they work, when they are (and are not) appropriate for clients and which ETFs from which providers work the best.

Give us a call to learn more about what ETFs can do for your portfolio and to discuss your investment needs