If you haven't thought much about exchange-traded funds (ETFs), now's a good time to become interested. Reason: Mutual fund giant Vanguard has jumped into the game.
As explained in the story above, ETFs hold a basket of stocks, as mutual funds do. But ETFs track an index, such as the S&P 500, Dow Jones Industrial Average or even foreign indexes, including Morgan Stanley's index of issues trading on the Tokyo Stock Exchange.
Industry-based ETFs also exist, such as iShares Goldman Sachs Networking Index Fund, which holds technology stocks and enjoyed a spectacular year in 2003.
Why should you consider ETFs? Here are three good reasons:
1. ETFs trade all day long, which precludes some of the illegal and unethical trading practices that caused the mutual fund scandals.
2. ETFs can be more flexible than mutual funds. Some mutual funds hit you with redemption fees if you buy and sell within, say, 90 days. That's not the case with ETFs, which you can trade when you like.
3. ETFs can be less expensive and more tax-efficient than index mutual funds. But you will incur transaction costs with ETFs, so you may do better working with a low-cost discount broker.
What's new about ETFs? Vanguard recently became a player in ETFs. The fund giant launched 16 "VIPER" ETFs, with six more expected soon. With Vanguard in the mix, other ETF sponsors will feel pressure to make their ETFs less expensive and less taxing.
What are the tax advantages?
Mutual fund investors buy and sell shares from and to the fund itself. But investors trade ETFs among themselves. So with an ETF, you're not buying someone else's tax liability. This helps make them tax-efficient.
For example, suppose you buy a small-cap index fund. The best performing stocks will become mid-caps, so they won't be in the index any more. A mutual fund will have to sell those stocks, take profits and pass the taxable gains through to shareholders. You might invest in a mutual fund on April 1 and owe tax on a trade that the fund makes on April 2, even though you didn't participate in the gain.
By comparison, ETFs can use techniques that minimize taxes on such phantom gains. Your basis is the price you pay for the shares. You'll have a taxable gain or loss, depending on the price you get when you sell the ETF shares. You control your tax obligations.