Exchange-Traded Funds

  • ETFs can provide access to the performance of an index in one purchase.
  • ETFs can fit well with other types of investments in the same portfolio.
  • ETFs are typically passively managed and can carry lower management fees .

A different take on fund investing?

An Exchange-Traded Fund (ETF) is an investment product holding a basket of assets. They work in one of two ways. Most ETFs are designed to track the performance of an index, sector, or commodity. A few are actively managed.

ETFs trade on an exchange like a stock. They are similar to mutual funds in the way that you own shares of an overall portfolio.

ETFs are transparent and typically liquid and low cost. Their transparency allows investors to see the portfolio’s holdings daily, instead of every 90 days, the disclosure standard for mutual funds.

ETFs in your portfolio

ETFs can be traded whenever the market is open. A mutual fund is bought or redeemed at the end of a day's trading.

ETFs provide a variety of exposures and can be useful in building a diversified portfolio. You and your Financial Advisor can use ETFs to access broad or specific parts of the market. They can also help provide access to parts of the market not easily accessible to individual investors.

Let’s say you wanted to own all stocks in the S&P 500 Index. It could be difficult and costly. Instead, you could gain broad exposure to the market could be accessed through an ETF that tracks the S&P 500 Index. This investment should closely mirror the performance of the underlying index and can be purchased through a single transaction.

There are also specialized ETFs. You can invest in both core and alternative asset classes. Commodities are examples of alternative asset classes. Through a diversified ETF, you might moderate the risk of owning a single security in an alternative asset class.

ETFs can fit well with other types of investments in the same portfolio. That’s one reason why some investors think of them as portfolio management tools.

Wide variety of Exposures

infographic - An ETF is a fund that trades like a stock

You may find an ETF for almost every market segment. ETFs can track sector-specific, country-specific, Fixed Income Sectors and broad-market indexes.

Most ETFs are passively managed. This means the investments in the ETF are selected to match the returns of an index. Less common are ETFs that are actively managed and have an an investment objective (e.g., to outperform a certain benchmark) as opposed to attempting to replicate the performance of an index.

Bought and sold like stocks

ETFs can be traded whenever the market is open. This is considered a key benefit because you can react more quickly to market conditions. A mutual fund is bought or sold only at the end of a day's trading.

The price of your ETF investment will fluctuate during the day with the ups and downs of the market. At times, an ETF may trade higher or lower – at a premium or a discount – from the price of its underlying securities or Net Asset Value (NAV). However, the creation/redemption mechanism, which usually takes place in-kind as opposed to in cash, facilitates a tight premium discount to NAV.

You can carry out the same types of trades as you would with a stock. You can also use a market order, limit order, use a stop-loss order, or buy on margin and in some cases sell short.

Investment cost is low

A single transaction can provide ownership in a basket of investments. It costs less to purchase an ETF than if you tried to acquire all the individual stocks in an index.

ETFs typically carry lower management fees and are passively managed. Fees can vary depending on the fund. Ask your Financial Advisor to help you understand the costs associated with a particular investment.

Know what you own

It’s easy to find out what you own in an ETF. The underlying investment holdings are viewable daily on the fund sponsor’s website. Knowing what the fund invests in is important information to understand. This will help you know if you are overweight in a particular stock or industry.

Potentially tax-friendly investments

Most ETFs are passively managed and as such, the investment securities/assets are chosen by predetermined guidelines to match an index or portion of the market. As a result, the portfolio has low turnover and usually generates few, if any, capital gains.

While Wells Fargo Advisors does not offer tax advice, it is useful to know ETFs might offer certain tax advantages. Your tax advisor can discuss these with you in greater detail.

ETF dividends

ETFs generally have low turnover and often generate fewer capital gains due to the low turnover of the securities in the fund.

You may receive two types of dividend income from an ETF holding:

Qualified dividends –Qualified dividends are dividends paid to investors in common and preferred stocks of US Corporations, and those paid by certain foreign corporations. Shareholders must satisfy a certain holding period to qualify for special tax treatment. The tax rate on qualified dividends is 15% or 20%, depending on your income tax bracket.

Non-qualified dividends – Non-qualified dividends are taxed at your ordinary income tax rate. They may come from short-term mutual fund capital gains, Real Estate Investment Trusts (REITs), or money market funds, among other sources.

Note that, while very rare, ETFs may distribute capital gains at year end.

Next Steps

  • Understand the potential investment, cost, and tax advantages of ETFs.
  • Learn how to view online the investment holdings within your ETF.
  • Ask your Financial Advisor which ETFs might work best in your portfolio.

ETFs are subject to risks similar to those of the underlying asset class. Investment returns may fluctuate and are subject to market volatility so that an investors’ shares may be worth more or less than their original cost when redeemed or sold. ETFs seek investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched.

Wells Fargo Advisors and its affiliates do not provide tax or legal advice. Please consult with your tax and/or legal advisors before taking any action that may have tax and/or legal consequences.