As ETFs have proliferated, so too have the questions surrounding them. While some queries can be technical, they more typically boil down to five basic questions. Here’s your guide to one of the most versatile investment vehicles around.
1. Do ETFs invest only in stocks?
No. Although the earliest ETFs invested solely in stocks, today they invest in everything from U.S. Treasury bonds and gold to oil futures and even volatility contracts. While there aren’t any ETFs yet that invest in, say, collectible wine or fine art, the range of investable assets in ETFs is impressive—and one of the features investors appreciate most.
2. How useful are star ratings when researching ETFs?
Not very. Actively managed mutual funds, index mutual funds and ETFs are all lumped together by category for star-rating purposes. However, while most actively managed mutual funds aim to outperform their benchmark indexes—and are rated higher when they do—most ETFs aim to track their benchmark indexes. So you’d expect ETFs to fall in the middle of the pack when it comes to performance, with actively managed mutual funds either outperforming or underperforming the benchmark-tracking ETFs. If an ETF is rated lower—say, one or two stars—this suggests that most actively managed mutual funds in the category outperformed the benchmark, not that the ETF performed poorly. More useful factors to consider are an ETF’s assets under management, bid-ask spread and expense ratio.
3. Do bond ETFs have maturity dates, like conventional bonds?
Not normally. Most bond ETFs are intended to operate in perpetuity (just like bond mutual funds). If the ETF owns a bond that matures, the fund manager ordinarily reinvests the proceeds in other bonds so that the portfolio continues paying interest.
That said, a few bond ETFs attempt to “mature” like traditional bonds. These ETFs own a basket of bonds from various issuers that all mature or are expected to be called by the issuer in a given year.
Once all the bonds have matured or been called, the ETF closes down and distributes the resulting cash to shareholders. These ETFs can be useful for investors who want a large distribution of cash at a predictable point in the future, but who desire more diversification than any single bond can offer. Unlike traditional bonds, however, a bond ETF doesn’t promise to pay a particular amount at maturity, just your portion of the money realized from the bonds that mature, based on your number of shares.
4. What order type should I use when buying or selling ETF shares?
It depends entirely on your goals:
- If you’re looking to buy or sell quickly, a market order tells your broker to buy or sell shares immediately. This offers speed but not price—in fact, you could end up buying or selling at a price you don’t like, especially if the market is moving quickly.
- If, on the other hand, you want to specify the price at which your shares are bought or sold, a limit order is likely what you want—though the trade might not be executed at all if there’s not a market for your stipulated price.
- For those looking to optimize speed and price, a “marketable” limit order specifies the most you’re willing to pay (generally a little higher than the current asking price) or the least you’re willing to accept (generally a little lower than the current bid price). For example, if the ask is $21.55, you could place a limit order to buy at $21.58; conversely, if the bid is $21.52, you could place a limit order to sell at $21.49. Neither precludes you from buying or selling at the prevailing price; however, both tell your broker to execute your trade right away—unless the market moves outside the limits set by your “marketable” limit order.
5. Why do ETFs occasionally shut down completely—and what happens when they do?
Not surprisingly, ETF providers generally shutter a fund for business reasons. For example, this often happens when an ETF fails to reach or falls below the minimum assets under management required for profitability. When this occurs, the provider normally makes an announcement weeks in advance, at which point many investors liquidate their shares. Selling your shares before the ETF actually shuts down is usually simpler for tax purposes.
Those who retain their shares until the fund closes typically receive a cash distribution once the ETF’s remaining assets have been liquidated. The distribution per share will ordinarily be close to the net asset value per outstanding share at the time of the fund’s closing; however, it can be lower if the ETF’s assets prove particularly difficult to sell. What’s more, there may be tax consequences from receiving this distribution if the ETF’s assets sell at a value greater than that at which the ETF acquired them.
Michael Iachini, CFA®, CFP®, is vice president of mutual fund and ETF research at Charles Schwab Investment Advisory, Inc.