How to Choose an Exchange-Traded Fund
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By Dow Jones

Exchange-traded funds began trading more than 15 years ago, but in recent years they've been gaining in popularity against more mature mutual funds.

An ETF's underlying net asset value is calculated by taking the current value of the fund's net assets (the value of all securities inside minus liabilities) divided by the total number of shares outstanding. The net asset value, or NAV, is published every 15 seconds throughout the trading day. But the ETF's NAV isn't necessarily its market price. More on that in a bit.

When you purchase shares of a traditional mutual fund, the net asset value serves much like a stock price — it's the price at which shares are bought or sold from the fund company. At a traditional fund, the NAV is set at the end of each trading day.

ETFs, as noted, work a bit differently. Since ETFs trade like a stock, you buy and sell shares on an exchange at a price determined by supply and demand. That's why an ETF's market price can differ from its net asset value. The way ETF shares are structured helps keep the gap between those two figures pretty tight.

Many investors — including the pros — have taken notice of these funds. Money invested in ETFs has more than quintupled over the past five years. The number of existing ETFs has skyrocketed at the same pace — investors now have hundreds to choose from. That number is still pretty small compared to the thousands of mutual funds that exist, but it is a lot of growth. And there are hundreds more on the way.

Investors like ETFs for several reasons:

Costs: Many good ETFs have very low fees, compared with traditional mutual funds.

Taxes: ETFs are big winners at tax time. As with any index fund, the manager of the ETF doesn't need to constantly buy and sell stocks unless a component of the underlying index that the ETF is attempting to track has changed. (This can happen if companies have merged, gone out of business or if their stocks have moved dramatically). And given the special way ETFs are structured (trust us, you don't want to know how this works), they're often more tax-efficient than traditional index mutual funds.

Diversification: Like index funds, ETFs provide an efficient way to invest in a specific part of the stock or bond market (say, small-cap stocks, energy or emerging markets), or the whole shebang (like the Standard & Poor's 500).

Open Book: Again, since they track an index, you usually know exactly what's inside an ETF. With traditional mutual funds, holdings are usually revealed with a long delay and only periodically throughout the year (mutual funds that track a specific index are the exception here).

User-Friendliness: ETFs can be bought or sold at any time during the day, just like stocks. Mutual funds, on the other hand, are priced only once at the end of each trading day. If you're investing for the long-term, this doesn't really matter. It is nice to know, however, that you can usually get out of an ETF at any time during the trading day.

Should You Buy an ETF?

There are a few situations where ETFs come in handy:

  • If you have a chunk of money you'd like to invest — say if you're rolling money over from an old 401(k) to an IRA — ETFs could be a smart choice.

But if you want to regularly build on that investment a bit each month, stick with mutual funds that allow you to buy in without paying brokerage fees. Paying a commission will eat into your returns. And there are at least a handful of good mutual funds to choose from that track the big, popular stock indexes.

  • If you don't have the $2,000 minimum investment required by some mutual funds, you can use ETFs as an alternative. You can assemble a decent portfolio with as few as three ETFs.
  • ETFs can perform the same acrobatics that stocks can. You can buy option contracts on many ETFs, and they can be shorted or bought on margin. Note: We don't recommend that you try this as a long-term investor – leave these moves to the professionals.

How to Get a Good Deal on an ETF

You'll want a high-quality ETF that fits into your investment plan, so you must evaluate ETFs the same way you would any other mutual fund.

When considering an ETF, ask the following questions: What does the index track, how is it constructed, what's inside and how long has it been around?

While ETFs that track long-standing indexes such as the S&P 500 and Russell 3000 have stood the test of time, many ETF creators are stretching the definition of indexing. Meanwhile, some have cooked up new indexes that track arcane segments of the market. As a long-term investor, you want to avoid newfangled ETFs that track esoteric benchmarks.

Consider your costs before investing. An expense ratio tells you how much an ETF costs. The amount is skimmed from your account and goes towards paying a fund's total annual expenses.

The average ETF carries an expense ratio of 0.44%, which means the fund will cost you $4.40 in annual fees for every $1,000 you invest. The average traditional index fund costs 0.74%, according to Morningstar Investment Research. On the flip side, there's been a proliferation of more narrowly-focused and exotic ETFs – many of which are not only unproven, but more expensive. Avoid these funds unless you really know what you're doing.

Consider the tax consequences of your investment. Most ETFs are pretty tax-efficient because of the special way they are built. However, some ETFs are mimicking newer, less-static indexes that trade more often. These funds may trigger more capital gains costs.

Meanwhile, some ETFs that invest directly in precious metals, such as gold, are considered 'collectibles' and are taxed at a much higher rate. Gains on collectibles are taxed at a maximum rate of 28%, rather than the 15% long-term capital gains rate.

Don't forget that trading in and out of ETF shares can generate taxable gains, just like stocks.

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© 2014 Dow Jones. All rights reserved.

This material is authored by Dow Jones and was not authored by Merrill Edge. Assumptions, opinions and estimates constitute judgment from Dow Jones as of the date of this material and are subject to change without notice. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.

Diversification does not ensure a profit or guarantee against loss.

Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that shares, when redeemed or sold, may be worth more or less than their original cost.

Like other financial products, ETFs also have certain disadvantages, including the following:

  • ETFs generate brokerage commissions on every trade, so frequent rebalancing and dividend reinvestment can potentially erode their cost benefits.
  • There can be a difference in the value of an ETF and its corresponding index. ETFs trade on an exchange and, as a result, may trade at a premium or discount to the value of the portfolio's underlying holdings.
  • ETFs don't always fully match the performance return of their corresponding index because they have underlying management expenses. In addition, it is difficult for international and fixed-income ETFs to fully replicate their benchmarks.

Please note that ETFs are registered investment companies that have prospectuses containing detailed information about the fund, including expenses and risks. Some ETFs may also have product descriptions, which summarize key information about the ETF and explain how to obtain a prospectus. You should carefully consider the investment objectives, risks, charges, and expenses before investing in this product. This and other important information is included in the prospectus, which should be read carefully before investing.

Any tax statements contained herein were not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state or local tax penalties. Neither Merrill Edge nor its representatives provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.