Until recently, the best way to put together a portfolio of stock and bond index funds was to buy index mutual funds. Mutual funds issue shares that are priced after the close of each trading day; the share price is determined by the closing prices of the stocks held by the fund. Investors can buy or sell these shares each day after the shares have priced, and in many cases do not have to pay transaction fees for buying and selling the shares if they hold an account with the mutual fund company. Mutual fund company Vanguard pioneered stock index funds, and offers some of the lowest-fee index mutual funds. Vanguard’s S&P 500 Index fund, for example, is the largest US index fund.
However, over the last year and a half new products have hit the market that for our purposes have distinct advantages over index mutual funds. They are exchange traded funds, or ETFs.
Exchange traded funds are similar to index mutual funds. The key difference is that ETFs, instead of pricing once a day after the market closes, are traded throughout the day as if they were regular stocks. If you want to buy shares in an ETF, you buy them as you would buy a stock - namely from someone else who sells them to you on a stock exchange (thus the name “exchange traded funds”). Investors can calculate the value of ETFs during the day because the composition of the underlying portfolio - normally a published index - doesn’t change. For example, if the ETF tracks the S&P 500 index, investors can calculate at any given moment the value of all the stocks in the S&P 500 index and thus the underlying value of the S&P 500 index ETF. This underlying value is known as the net asset value, or NAV.
An important feature of ETFs is that financial institutions can exchange ETFs for the underlying assets they represent with the issuing institution for a small fee. This feature prevents ETFs from trading at systematic discounts or premiums to the value of the underlying assets of the fund. If, for example, an ETF trades at a premium to the value of its underlying assets, a smart institution will sell the ETF short and buy the basket of underlying stocks which it will then exchange for the ETF at actual value, thereby making a profit. The possibility and occurrence of this arbitrage prevents a gap opening between the traded price of the ETF and its net asset value.
ETFs have a tax advantage over mutual funds, that - while relatively small - is significant when compounded over time. Mutual index funds, despite their low stock turnover, still distribute some capital gains to their investors most years. Investors pay taxes on these capital gains. According to Lipper, S&P 500 index mutual funds distributed 2.03% of their net asset value as capital gains each year, on average, between 1993 and 2001. In contrast, the S&P 500 index ETF traded under the ticker (NYSEARCA:SPY) made only one capital gain distribution during that period, of 0.12% in 1996, and most S&P 500 ETFs are expected to make no capital gains distributions in future.
If you want to understand why this is the case, and you relish the intricacies of these instruments, read on. Otherwise, you may want to skip to the next section. Here goes. Imagine you buy some shares in the Vanguard 500 index mutual fund. Then, the following year there’s a mass exodus from that fund. Due to the large-scale redemptions, the Vanguard 500 fund is forced to sell assets to raise cash. The problem is that most investors may have bought shares in the fund when the S&P 500 index was trading at much lower prices. So when Vanguard sells the stocks in the S&P 500 to raise cash, it triggers a capital gain. It then sends a letter to all its shareholders informing them that they need to report a capital gain in their tax return, even though many of them did not sell their fund shares. You, who just bought fund shares, could get hit with a capital gains bill, even in the case where the shares have actually declined in value. In contrast, if institutions decide to liquidate their holdings of ETFs, they swap them for the underlying stocks in the fund (typically the lowest cost basis stocks), and the remaining fund holders do not receive a capital gains distribution. Also, institutions that are tax-exempt may be given shares with the lowest cost-basis, leaving the remaining shareholders with a lower unrealized capital gain. As I said, this tax advantage of ETFs over mutual funds is largely theoretical, unless some event or events trigger substantial asset withdrawals from traditional index mutual funds.