When investors want to sell their ETF holdings, they can do so by one of two methods. The first is to sell the shares on the open market. This is generally the option chosen by most individual investors. The second option is to gather enough shares of the ETF to form a creation unit, and then exchange the creation unit for the underlying securities. This option is generally only available to institutional investors due to the large number of shares required to form a creation unit. When these investors redeem their shares, the creation unit is destroyed and the securities are turned over to the redeemer. The beauty of this option is in its tax implications for the portfolio.
We can see these tax implications best by comparing the ETF redemption to that of a mutual fund redemption. When mutual fund investors redeem shares from a fund, all shareholders in the fund are affected by the tax burden. This is because to redeem the shares, the mutual fund may have to sell the securities it holds, realizing the capital gain, which is subject to tax. Also, all mutual funds are required to pay out all dividends and capital gains on a yearly basis. Therefore, even if the portfolio has lost value that is unrealized, there is still a tax liability on the capital gains that had to be realized because of the requirement to pay out dividends and capital gains.
ETFs minimize this scenario by paying large redemptions with stock shares. When such redemptions are made, the shares with the lowest cost basis in the trust are given to the redeemer. This increases the cost basis of the ETF's overall holdings, minimizing its capital gains. It doesn't matter to the redeemer that the shares it receives have the lowest cost basis, because the redeemer's tax liability is based on the purchase price it paid for the ETF shares, not the fund's cost basis. When the redeemer sells the stock shares on the open market, any gain or loss incurred has no impact on the ETF. In this manner, investors with smaller portfolios are protected from the tax implications of trades made by investors with large portfolios.
An ETF has many advantages over a mutual fund including costs and taxes. The creation and redemption process for ETF shares is almost the exact opposite of that for mutual fund shares. When investing in mutual funds, investors send cash to the fund company, which then uses that cash to purchase securities and in turn issues additional shares of the fund. When investors wish to redeem their mutual fund shares, they are returned to the mutual fund company in exchange for cash. Creating an ETF, however, does not involve cash.
The process begins when a prospective ETF manager (known as a sponsor) files a plan with the U.S. Securities and Exchange Commission to create an ETF. Once the plan is approved, the sponsor forms an agreement with an authorized participant, generally a market maker, specialist or large institutional investor, who is empowered to create or redeem ETF shares. (In some cases, the authorized participant and the sponsor are the same.)
The authorized participant borrows stock shares, often from a pension fund, places those shares in a trust and uses them to form ETF creation units. These are bundles of stock varying from 10,000 to 600,000 shares, but 50,000 shares is what's commonly designated as one creation unit of a given ETF. Then, the trust provides shares of the ETF, which are legal claims on the shares held in the trust (the ETFs represent tiny slivers of the creation units), to the authorized participant. Because this transaction is an in-kind trade — that is, securities are traded for securities—there are no tax implications. Once the authorized participant receives the ETF shares, they are sold to the public on the open market just like stock shares.
When ETF shares are bought and sold on the open market, the underlying securities that were borrowed to form the creation units remain in the trust account. The trust generally has little activity beyond paying dividends from the stock, held in the trust, to the ETF owners, and providing administrative oversight. This is because the creation units are not impacted by the transactions that take place on the market when ETF shares are bought and sold.
The use of exchange traded funds (ETFs) has increased rapidly in recent years. If you're just getting started with ETFs, here are a few basics to help get you oriented on these convenient, low-cost, flexible funds.
One: ETFs and mutual funds are similar in many ways, with several key differences.
Like mutual funds, ETFs are bundles of securities, such as stocks or bonds. Both ETFs and mutual funds make it easy to gain exposures to a wide range of markets.
A key difference between ETFs and mutual funds is how they are bought and sold. Mutual funds are traded directly with the fund company and shares are priced once a day, after the market close (4 p.m. Eastern). ETF shares, on the other hand, can be bought and sold throughout the day at market price when the market is open, just like a stock.1
Two: They have been around for a long time.
ETFs have been widely covered in the media over the past few years, but they are not new. U.S. stock ETFs have been around for more than two decades, and the first bond ETF was introduced in 2002. Today, ETFs have grown more than $3 trillion worldwide,2 as all types of investors turn to them to meet a wide variety of financial goals.
Three: ETFs are cheaper to own than the typical mutual fund.
Costs have a direct impact on your bottom line. Many investors are drawn to ETFs because they're generally cheaper to own.3 Those savings can really add up year after year. Also, if taxes are a concern, many ETFs have historically had lower taxable capital gains distributions than mutual funds.4 The result? ETFs may help you keep more of what you earn.
Four: ETFs come in virtually any "flavor" you can think of.
You can choose from more than 1,800 ETFs5 in the U.S. alone. ETFs are designed to help with a wide range of investment goals, including:
Core building blocks tracking major U.S. and global stock and bond markets
Exposure to specific sectors, countries, or other parts of the market
Targeted objectives such as generating an income stream or minimizing volatility
Combined with their low costs and ease of use, ETFs are a very versatile investment product.
Five: Choose your ETF provider as carefully as you choose your ETF.
There are a lot of ETFs out there, but they aren't all created equal. Just like with mutual funds, two ETFs may sound similar, but behave quite differently from each other. Factors such as fees, tax and trading costs and index management can all affect performance and returns. So when choosing individual funds, investors should also do some due diligence on the fund providers. Among the traits to look for: a proven record of strong ETF expertise, a commitment to quality, and enough scale to make trading efficient and liquid.
By Money & Finance
Ok... I will begin to share my investment ideas list. I am hoping some of you will challenge me on these or even better surprise me with better opportunities.
Remember that these are stock investments to hold for decades not just quick trades.
Uber is quickly changing the transportation infrastructure of our world.
Twitter - I feel this stock has been beaten up and will eventually get bought out by Apple.
Netflix - They have some of the most compelling content on "TV" right now and have a massive subscriber base.
Coca-Cola - Because this will always be around
TJ Maxx - Women just love the hunt and this store seems to just keep on ticking.
I will also now add Amazon to my list: View the following video....