Three Popular ETF Questions Answered

   

Although exchange-traded funds, commonly known as ETFs, have existed for almost two decades, they’ve only recently caught on with investors. The ETF market has evolved, and investors now have hundreds of ETFs from which to choose. Here are three commonly asked questions to consider when adding ETFs to a portfolio.

Q: What is the difference between the ETF market price and net asset value (NAV), and why do ETFs trade at a premium or discount?

A: An ETF’s NAV is the value of all the fund’s assets divided by the total number of shares. This calculation is done at the close of each trading day and can be affected by changes in the market value of the underlying securities. The market price is the price at which the ETF is trading on the exchange, which can be affected by supply and demand. During times when demand for an ETF exceeds supply, the market price of the ETF is higher than its NAV and the ETF is said to trade at a premium; when supply exceeds demand, the market price of the ETF is lower than its NAV and the ETF is said to trade at a discount. ETFs generally do not trade at persistent large premiums or discounts.

Q: What are the tax advantages of ETFs?

A: Taxable capital gains are realized when a fund buys and sells securities at a profit, which is then passed on to investors. When an ETF buys and sells (creates and redeems) shares, it is usually done in-kind, which means no cash is involved, as ETF shares are exchanged for an equivalent basket of its underlying securities instead. This helps the ETF to minimize realizing and then passing taxable capital gains on to investors.

Q: Is it a good idea to use ETFs in retirement accounts?

A: Buying and selling ETFs incurs a brokerage fee, along with other potential costs. If an investor makes frequent contributions, brokerage fees can add up and pose a significant drag on long-term performance. Different plan providers will charge participants differently. That said, several brokerage platforms offer commission-free trades for certain families of ETFs, so check with your plan provider.

Holding an exchange-traded fund does not ensure a profitable outcome and all investing involves risk, including the loss of the entire principal. Since each ETF is different, investors should read the prospectus and consider this information carefully before investing. The prospectus can be obtained from your financial professional or the ETF provider and contains complete information, including investment objectives, risks, charges and expenses. ETF risks include, but are not limited to, market risk, market trading risk, liquidity risk, imperfect benchmark correlation, leverage, and any other risk associated with the underlying securities. There is no guarantee that any fund will achieve its investment objective. In addition to ETF expenses, brokerage costs apply. Fees are charged regardless of profitability and may result in depletion of assets.

The market price of ETFs traded on the secondary market is subject to the forces of supply and demand and thus independent of the NAV. This can result in the market price trading at a premium or discount to the NAV which will affect an investor’s value. The market prices of ETF’s can fluctuate as a result of several factors, such as security-specific factors or general investor sentiment. Therefore, investors should be aware of the prospect of market fluctuations and the impact it may have on the market price. ETF trading may be halted due to market conditions, impacting an investor’s ability to sell the ETF. Please consult with a financial or tax professional for advice specific to your situation.