Look before you leap when investing in ETFs

Exchange traded funds (ETFs) offer investors a basket of securities and other assets similar in many ways to a mutual fund, except that shares in an ETF can be bought and sold throughout the day like a stock. Financial institutions purchase and redeem ETF “creation units” (shares), which can trade at a discount or premium of net asset value directly from ETF providers.

While generally providing easy diversification, low expense ratios, and tax efficiency, ETFs maintain all the features of ordinary stock, such as limit orders, short selling, and options.

The first ETFs started in the U.S. in 1993 and functioned initially like index funds. In 2008, the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs. The industry has experienced rapid growth, and today there are about 1,000 ETFs with estimated assets of more than $800 billion.

Unlike mutual funds, ETF sponsors typically assign specific securities to each fund and generally do not experience cash flows into or out of the fund. This can be an advantage over mutual funds, which are required to periodically distribute capital gain to all investors in proportion to their ownership. With well-established ETFs, investors have generally been able to pay very little capital gain tax until they sell their interest. However, in recent years certain funds from top ETF firms have been realizing more substantial trading profits, which they are required to pass through as taxable capital gain. This is more likely for newer ETFs (launched after 2005).

Some newer ETFs are organized as partnerships or trusts, requiring sponsors to provide K-1s. Other ETFs may be totally different animals in terms of taxation because of exposure to foreign currencies, metals, and other holdings. An ETF that holds gold, for example, would generate gains subject to the higher federal tax rate on collectibles (28 percent instead of 15 percent). ETFs can hold futures-based funds, which are look- through vehicles for tax purposes. Futures contracts with a mark-to-market methodology can require recognition of gain even if you sell nothing, making paper profits taxable.

Aside from the recent glitches with some of the newer ETF with hidden tax traps, the wide variety of traditional ETF offerings based on index strategies continues to offer appeal to investors.

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