Search

What are Exchange-Traded Funds (ETFs) and ETF Wraps?

By: , dated January 25th, 2013

ETFs, or Exchange-Traded Funds, have become the new darlings of the investment world. Although they function much like mutual funds (by diversifying risks by including many investments in the same basket and thus spreading risk), ETFs offer a number of unique advantages to investors. ETFs have far lower expense ratios due to the fact that there are no management or administration fees assessed to the investor. These fees are unnecessary because ETFs are not actively managed. Instead, ETFs are created so that they mirror the results of major indexes such as the NASDAQ 100 or S&P 500. Once the ETF is created, there is no active management, but adjustments may be made to make sure that results are in line with the underlying index. This means that if the results begin to vary from those reported by the underlying index, the ratios of stocks composing the ETF may need some adjustment.

In addition to lower expense ratios, ETFs are traded intraday (all day long) instead of only once per day like mutual funds. When conditions are volatile and prices are moving rapidly in one direction or another, the increased liquidity of ETFs might be considered a big advantage over mutual funds – at least for more active investors. ETF wraps are recent innovations and they are similar to mutual fund wraps except that the underlying investments are ETFs. And just like mutual fund wraps, ETF versions are also available in two basic versions: discretionary and non-discretionary.

Discretionary ETF Wraps

Discretionary ETF wraps are really nothing special, but they do allow the investor to choose the investment allocation model best suited to his/her needs. There are a number of allocation models for investors to choose from including equity, balanced, and fixed-income. Investors can choose models with 100% of the assets assigned to equities, or to fixed-income investments. Balanced allocation models start with the standard 80%-equity/20%-fixed-income split and include a number of variations.

What many investors will find interesting about discretionary ETF wraps is that they are actively managed by money managers. These investment professionals are paid to select the investments, track performance, and rebalance the ETF wrap to make sure it is in line with the asset allocation model selected by the investor.

Non-Discretionary ETF Wraps

Non-discretionary wraps are not actively managed by an investment professional. This means that the investor is responsible for setting up their own asset allocation model. The investor will then need to select the ETFs best suited for that model and monitor the wrap to make sure performance is within acceptable ranges. The investor will also have to rebalance to keep the wrap in line with the asset allocation model.

The big question is whether or not ETF wraps offer an investor any potential advantages over the mutual fund variety. Where pricing is concerned, ETF wraps are definitely less expensive than mutual fund wraps – but why?

One of the big reasons why ETFs remain so much less expensive than mutual funds is because there are no management fees or expenses charged for maintaining the account. But at least with discretionary wraps, there is active oversight on the part of a money manager and therefore management fees are charged.

The reason why ETF wraps remain less expensive than the mutual fund variety is because of the underlying investments themselves – the ETFs!! The ETF expense ratio is still so low, even as the underlying investment, that the ETF wraps are still less expensive than the mutual fund variety – even though both have management fees (non-discretionary wraps also have fees but they are much lower than for the discretionary variety).

ETF wraps also offer certain tax considerations not available with the mutual fund wraps. When buying any mutual fund other than those that have just been created, an investor has the risk of inheriting some capital gains that will be incurred at the next distribution. However, capital gains are less of an issue for ETFs because redemptions can often be offset by distributions of the underlying stocks. In other words, if an ETF holder were to receive a dividend – it is often possible for the investor to receive that distribution in shares of the underlying stock. No cash actually changes hands and any potential gains can be offset until the investor liquidates his holdings.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

Copyrighted by InvestorGuide.com. All rights reserved.

Leave a Reply