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1.
ETFs have special tax-related advantages relative to mutual funds. Which statement is incorrect?
ETF investors must pay a tax every time they invest in an ETF. ETF investors do not need to pay a tax each time they invest in an ETF. Meanwhile, it is indeed true that redemptions by large ETF investors are paid in kind, protecting shareholders from taxable events, and it is also true that most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions. Finally, its also true that regular mutual fund investors can suffer when mass investor selling occurs. This is because large investor selling can drive mutual fund portfolio managers to have to sell stocks in order to meet redemptions, and that act can result in mutual funds needing to make taxable capital-gains distributions to shareholders.
2.
What is the best way for an investor to invest in a highly focused ETF?
To be contrarian, and to not chase whats been hot recently. The ETF universe has literally hundreds of ETFs that focus on a single market sector, industry or geographic region. However, too often, by the time a hot-performing market segment catches investors eyes, that segment is about to cool down -- at least, in the short term. Unfortunately, investors often pursue those corners of the market at precisely the wrong time. As a result, investors should not necessarily invest in focused ETFs that have attracted significant recent investor interest.
3.
Why are ETFs expense ratios generally lower than those of open-end mutual funds?
All of the above. ETFs indeed can and do passively track the performance of virtually any kind of index, with very few actively managed ETFs currently trading. ETF providers also dont have to manage hundreds of separate customer accounts or need to staff call centers, and they dont need to pay active portfolio managers the large salaries that mutual fund companies do. Finally, ETFs do indeed trade on an exchange, meaning that transactions occur directly between investors.
4.
Exchange-traded funds _______ make capital-gains distributions.
Do. They simply do so less often than mutual funds do.
5.
In what circumstance would an ETF investor wind up paying more by using an ETF than by investing in an open-end mutual fund, even if the ETFs expense ratio were lower?
The investor regularly invests small sums of money in an ETF. Investors pay a brokerage commission each time they buy and sell an ETF, so their costs mount with each trade. Commissions can add up quickly, so if with periodic investments over time, investors overall costs could be lower with a no-load mutual fund. Industry-specific and index ETFs still would be cheaper than an open-end mutual fund if the ETF had a lower expense ratio. And the size of the ETF provider does not matter as much as the stated expense ratio.
