Investing in ETFs For Dummies. Russell Wild

majority of ETFs, which are index funds. Because index funds trade infrequently, and because of ETFs’ poker-chip structure, ETF investors rarely see a bill from Uncle Sam for any capital gains tax. That’s not a guarantee that there will never be capital gains on any index ETF, but if there ever are, they are sure to be minor.

      The actively managed ETFs – currently a very small fraction of the ETF market, but almost certain to grow – may present a somewhat different story. They are going to be, no doubt, less tax friendly than index ETFs but more tax friendly than actively managed mutual funds. Exactly where will they fall on the spectrum? It may take another year or two (or three) before we really know.

      

Tax efficient does not mean tax-free. Although you won’t pay capital gains taxes, you will pay taxes on any dividends issued by your stock ETFs, and stock ETFs are just as likely to issue dividends as are mutual funds. In addition, if you sell your ETFs and they are in a taxable account, you have to pay capital gains tax (15 to 20 percent) if the ETFs have appreciated in value since the time you bought them. But hey – at least you get to decide when to take a gain, and when you do, it’s an actual gain.

      ETFs that invest in taxable bonds and throw off taxable bond interest are not likely to be very much more tax friendly than taxable-bond mutual funds.

      ETFs that invest in actual commodities, holding real silver or gold, tax you at the “collectible” rate of 28 percent. And ETFs that tap into derivatives (such as commodity futures) and currencies sometimes bring with them very complex (and costly) tax issues.

      Taxes on earnings – be they dividends or interest or money made on currency swaps – aren’t an issue if your money is held in a tax-advantaged account, such as a Roth IRA.

What you see is what you get

      A key to building a successful portfolio, right up there with low costs and tax efficiency, is diversification. You cannot diversify optimally unless you know exactly what’s in your portfolio. In a rather infamous example, when tech stocks (some more than others) started to go belly up in 2000, holders of Janus mutual funds got clobbered. That’s because they learned after the fact that their three or four Janus mutual funds, which gave the illusion of diversification, were actually holding many of the same stocks.

       Style drift: An epidemic

      

With a mutual fund, you often have little idea of what stocks the fund manager is holding. In fact, you may not even know what kinds of stocks he is holding. Or even if he is holding stocks! I’m talking here about style drift, which occurs when a mutual fund manager advertises his fund as aggressive, but over time it becomes conservative, and vice versa. I’m talking about the mutual fund manager who says he loves large value but invests in large growth or small value.

      One classic case of style drift cost investors in the all-popular Fidelity Magellan Fund bundle. The year was 1996, and then fund manager Jeffrey Vinik reduced the stock holdings in his “stock” mutual fund to 70 percent. He had 30 percent of the fund’s assets in bonds or short-term securities. He was betting that the market was going to sour, and he was planning to fully invest in stocks after it did. He was dead wrong. Instead, the market continued to soar, bonds took a dive, Fidelity Magellan seriously underperformed, and Vinik was out.

      One study by the Association of Investment Management concluded that a full 40 percent of actively managed mutual funds are not what they say they are. Some funds bounce around in style so much that an investor would have almost no idea where her money was.

       ETFs are the cure

      When you buy an indexed ETF, you get complete transparency. You know exactly what you are buying. No matter what the ETF, you can see in the prospectus or on the ETF provider’s website (or on any number of independent financial websites) a complete picture of the ETF’s holdings. See, for example, http://finance.yahoo.com. If I go and type the letters IYE (the ticker symbol for the iShares Dow Jones U.S Energy Sector ETF) in the box on the top of the page, and then click the Holdings link on the left, I can see in an instant what my holdings are.

      You simply can’t get that information on most actively managed mutual funds. Or if you can, the information is both stale and subject to change without notice.

       Transparency also discourages dishonesty

      The scandals that have rocked the mutual fund world over the years have left the world of ETFs untouched. There’s not a whole lot of manipulation that a fund manager can do when his picks are tied to an index. And because ETFs trade throughout the day, with the price flashing across thousands of computer screens worldwide, there is no room to take advantage of the “stale” pricing that occurs after the markets close and mutual fund orders are settled. All in all, ETF investors are much less likely ever to get bamboozled than are investors in active mutual funds.

      Getting the Professional Edge

      I don’t know about you, but when I take the kids bowling and – as happens on very rare occasion – I bowl a strike, I feel as if a miracle of biblical proportions has occurred. And then I turn on the television, stumble upon a professional bowling tournament, and see guys for whom not bowling a strike is a rare occurrence. The difference between amateur and professional bowlers is huge. The difference between investment amateurs and investment professionals can be just as huge. But you can close much of that gap with ETFs.

Consider a few impressive numbers

      By investment professionals, rest assured I’m not talking about stockbrokers or variable-annuity salesmen, or my barber, who always has a stock recommendation for me. I’m talking about the managers of foundations, endowments, and pension funds with $1 billion or more in invested assets. By amateurs, I’m talking about the average U.S. investor with a few assorted and sundry mutual funds in his 401(k).

      Let’s compare the two: During the 20-year period 1990 through 2009, the U.S. stock market, as measured by the S&P 500 Index, provided an annual rate of return of 8.2 percent. Yet the average stock mutual fund investor, according to a study by Dalbar, earned an annual rate of 3.2 percent over that same period, just barely keeping up with the inflation rate of 2.8 percent a year. Bond-fund investors did much worse. Why the pitiful returns? There are several reasons, but two main ones:

      ✔ Mutual fund investors pay too much for their investments.

      ✔ They jump into hot funds in hot sectors when they’re hot and jump out when those funds or sectors turn cold. (In other words, they are constantly buying high and selling low.)

      Professionals tend not to do either of those things. To give you an idea of the difference between amateurs and professionals, consider this: For that very same 20-year period in which the average stock mutual fund investor earned 3.2 percent, and the average bond mutual fund investor earned 1 percent, the multibillion-dollar stock-and-bond-and-real-estate California Public Employees’ Retirement System (CALPERS) pension fund, the largest in the nation, earned nearly 8 percent a year.

You can do what they do!

      Professional managers, you see, don’t pay high expenses. They don’t jump in and out of funds. They know that they need to diversify. They tend to buy indexes. They know exactly what they own. And they know that asset allocation, not stock picking, is what drives long-term investment results. In short, they do all the things that an ETF portfolio can do for you. So do it. Well, maybe … but first read the rest of this chapter!

      Passive versus Active Investing: Your Choice

      Surely, you’ve sensed by now my preference for index funds over actively managed funds. Until recently, all ETFs were index funds. And in the past few years, most index funds have been ETFs.

      On March 25, 2008, Bear Stearns introduced an actively managed ETF: the Current Yield ETF (YYY). As fate would have it, Bear Stearns was just about to go under, and when it did, the first actively managed ETF went with it. Prophetic? Perhaps. In the years since, about 130 actively managed ETFs, from 29 providers, have hit the street,