The exchange traded fund market has continued to grow with assets from both institutional and individual investors alike. As the business becomes more commonplace with retail investors, the need for more ETF education is growing.
Certain aspects of an exchange traded fund investing may not be understood by some investors. There are basic characteristics of ETFs such as structure and index construction that are important functions to how returns are generated. [Build a Diversified Investment Portfolio with 3 ETFs]
Many ETFs such as the SPDR S&P 500 (NYSEArca: SPY) track a basic benchmark such as the S&P 500 and is basic to understand, reports Roger Wohlner for The Chicago Financial Planner. As the ETF industry continues to expand, there are new benchmarks created and more niche funds created to cater to them.
The more complicated the index is, the harder it is to understand. The more complex indices are usually best left for sophisticated investors. A recent Vanguard report said that of the 1,400 ETFs trading, about 1,000 track hybrid or complex indices, reported by Chuck Jafffe. [Some Outperforming ‘Smart Beta’ ETFs]
A peek at how complicated index structure gets can start by looking at the large-cap growth sector – Schwab U.S. Large Growth Index (NYSEArca: SCHG), Vanguard Growth ETF (NYSEArca:VUG), and the iShares Russell 1000 Growth ETF (NYSEArca: IWF). All three ETFs track the same index style, but differ in sector weighting, top holdings, or companies held. [Large-Cap Equity ETFs Outperforming in 2013]
The structure of an ETF plays a big factor in how capital gains are treated at tax time. Some are structured as an open-ended fund, a share class of existing mutual funds, grantor trusts or a debt note. Many of these tax gains or distributions at different rates, so it is important to consider this aspect before investing.
Another area of caution for ETF investors are the free trades that have become common. A fee free ETF does not mean that operating costs are also free. In fact, these can add up. Also, the lure of an ETF for free can lead to using a fund that may not be necessary for ones investment objectives. Make sure the fund is high quality, as some brokerages may offer funds for free in an effort to ramp up illiquid products. [ETF Fees: Competition is a Good Thing]
The aforementioned merely scratches the surface on what investors should be researching when investing in ETFs. Proper knowledge of what one is investing in will help investors create an investment strategy using the right ETFs.
Tisha Guerrero contributed to this article.
Full disclosure: Tom Lydon’s clients own SPY.