Exchange-traded funds (ETFs) are increasingly popular among investors looking for cost-cutting diversification solutions, yet ETFs possess special characteristics which should be understood prior to investing.
ETFs trade like stocks on the stock market and can be bought or sold throughout the day, however they also hold baskets of assets which could cause tracking errors.
Taxes
Many investors opt to diversify their retirement portfolio with mutual funds or ETFs to take advantage of diversification and lower fees. ETFs share some similar investment advantages as mutual funds but may have their own set of operational nuances that impact how they should be utilized within an IRA account.
ETFs offer several operational nuances that distinguish them from mutual funds, including intraday buy and sell capabilities and fluctuating trading commissions or tracking errors that result in market price deviations from their net asset value (NAV).
ETFs that invest in physical precious metals require special consideration due to being treated by the IRS as collectibles; therefore if you own one and sell it at some point in time, your sales proceeds will be subject to tax at a rate up to 28% of original price paid for such collectibles.
Expenses
ETFs generally follow market indexes, and require less research and hands-on management compared with mutual funds, leading to lower expense ratios than mutual funds.
Investors can trade ETFs like stocks on an exchange, providing greater liquidity than mutual funds which must be bought and sold at their end-of-day net asset value (NAV). Furthermore, most ETFs do not charge front- or back-end loads that could increase initial investments amounts or final sale prices.
ETFs offer instant diversification. Want exposure to a new industry without picking individual winners? ETFs in that sector could be just the ticket; an excellent gold-rated example is Fidelity Total Bond ETF, ticker FBND, which tracks the Bloomberg US Aggregate Bond Index; it has higher expected returns but requires slightly more annual fees than its VCRB counterpart.
Trading
ETFs offer investors access to multiple markets at an economical cost. ETFs are especially suitable for use within an Individual Retirement Account as they can be bought and sold throughout the trading day without incurring a wash sale, and often come with lower fees than mutual funds.
As they are typically structured to limit capital gains distributions and minimize taxes upon withdrawal in retirement, ETFs tend to be more tax-efficient than some mutual funds.
ETFs offer several other distinct advantages over mutual funds, such as no front- and back-end sales loads and potential savings over the long haul.
If you lack the expertise or time necessary to oversee your own IRA investments, professional management such as target date funds or asset allocation funds may provide an easier alternative. These funds automatically diversify your portfolio with assets based on when your retirement year will likely come around and typically charge lower fees than ETFs.
Leveraged ETFs
An IRA allows you to hold multiple types of exchange-traded funds (ETFs), including dividend-paying ones. One popular choice is Schwab U.S. Dividend Equity ETF SCHD, which holds high dividend-paying stocks such as Broadcom AVGO and Texas Instruments TXN; or consider gold-rated iShares Core Total USD Bond Market ETF IUSB which tracks an index that includes both stocks and bonds.
However, you should use caution with leveraged ETFs as they may provide impressive returns but also magnify losses significantly – if an index followed by the ETF declines by even one percentage point, its share prices could decrease by more than two percentage points and vice versa.
Of note is the fact that leveraged ETFs use derivatives to reach their goals, leaving you exposed to additional risks not associated with their underlying index. As per FINRA recommendations, firms must carefully consider if their products are appropriate for retail customers by conducting an in-depth suitability analysis and making reasonable efforts to obtain information regarding each customer’s financial condition and investment goals.
