5 Exciting Facts About ETFs You Should Know!Get ready to dive into the world of ETFs, where understanding costs, dividends, and taxes can make all the difference!

Exchange-traded funds (ETFs) are exciting investment options that trade like stocks, meaning you can buy and sell them throughout the day as the market fluctuates! Unlike mutual funds, which are priced just once at the end-of-day net asset value (NAV), ETFs offer the thrill of seeing their prices change all day long.

Here are 5 intriguing questions and answers to help you dive into the world of ETFs!

1. Are all ETFs relatively cheap?

One of the fantastic features that has skyrocketed ETFs' popularity is their cost-effectiveness compared to other funds. The trend of declining expense ratios for both ETFs and mutual funds is largely due to fierce competition driving costs down.

Several exciting factors contribute to this trend, including expense ratios decreasing as fund assets grow, a shift towards no-load share classes for long-term mutual funds, economies of scale, investor preferences, and the competitive edge of ETFs.

While most comparable ETFs are indeed more affordable than mutual funds, not all ETFs are cheaper, so don't assume they are!

For instance, the mutual fund Fidelity^® 500 Index Fund (FXAIX) boasts a net expense ratio of just 0.015%, with no transaction fee on Fidelity.com.² This compares favorably with similar ETFs like the SPDR S&P 500 ETF (SPY) with an expense ratio of 0.09% and the iShares Core S&P 500 ETF (IVV) with an expense ratio of 0.03%. Plus, Fidelity offers zero expense ratio index mutual funds!

Remember, expense ratios aren't the only thing to consider when evaluating ETF costs. Tracking error, which measures how well the ETF tracks a benchmark, can impact the total return. If you're aiming to mirror a benchmark like the S&P 500^® Index, look for ETFs with minimal tracking error.

The bid-ask spread is another exciting factor to consider. An ETF with a wider bid-ask spread—the price difference between what buyers are willing to pay, and sellers want to receive—might be pricier. In contrast, mutual funds trade at the net asset value and aren't subject to a bid-ask spread. 

2. Do ETFs pay dividends?

Absolutely! If a stock in an ETF pays a dividend, then so does the ETF. How exciting is that?

While some ETFs distribute dividends as soon as they're received from each company, most pay out quarterly. Some ETFs hold the individual dividends in cash until the payout date, while others reinvest them back into the fund before distributing them as cash.

ETFs might even let you use dividends to purchase new shares instead of receiving cash. And certain brokers, like Fidelity, might allow you to reinvest dividends commission-free. You can check an ETF's prospectus to see if and how it pays dividends.

3. Are all ETFs passive?

Most ETFs are thrillingly designed to track an index, like the S&P 500^® Index, making them "passively managed." Any securities transactions by the fund aim to keep the portfolio aligned with the index.

"Smart beta" ETFs are a special category of passively managed ETFs that aim to enhance their return or alter their risk profile compared to a market benchmark. While they try to replicate benchmark exposures, their composition may differ from any market index as they're engineered for targeted factor exposure. This involves adjusting factors like growth or value relative to a market index. 

Some ETFs, however, are actively managed with the goal of outperforming a benchmark like the S&P 500. The fund manager may choose different securities or weights compared to the index the ETF seeks to outperform, adding an exciting twist to your investment strategy!

4. Are all ETFs tax-efficient?

When you're investing in a taxable account, taxes matter. Generally, passive ETFs are seen as tax-friendly because of their unique setup, lower portfolio turnover, and management style. One big perk of ETFs is that when you buy or sell shares, the ETF manager can match these trades with others, so they don't have to buy or sell the actual securities in the fund. This process helps avoid triggering a taxable event.

But remember, not all ETFs are equally tax-efficient.

For instance, ETF dividends are taxable, and those paying nonqualified dividends might not be as tax-friendly as those with qualified dividends. Annual distributions from an ETF can be either qualified or nonqualified dividends. Qualified dividends get taxed at a max of 15%. However, even if an ETF says its distribution is qualified, it doesn't automatically mean it is for you. You need to have held the ETF for at least 61 days during the 121-day period that starts 60 days before the ex-dividend date. Like with mutual funds, ETF investors are subject to tax rates on distributions, whether they're dividends from stocks or bond interest.

You can invest tax-efficiently in ETFs by picking ones that minimize capital gains distributions and focus on qualified dividends. Also, consider keeping tax-inefficient ETFs in tax-deferred or tax-free accounts. If you're worried about taxes, it's a good idea to talk to a tax advisor.

5. Are all ETFs relatively liquid?

ETFs are pretty flexible compared to similar mutual funds because you can trade them throughout the day and place limit orders. But that doesn't mean all ETFs are super liquid (meaning you can buy or sell them easily at the current market price).

There are a few ways to find liquid assets, including ETFs. A low bid-ask spread can suggest a strong market of buyers and sellers, though it might not reflect the spread for trades of different sizes. Another sign of liquidity is the average daily volume, which is the number of shares traded. Investments with high volume and more liquidity tend to be more efficient.

Best Regards,

Stock Market Charlie