Exchange Traded Funds - A Possible Solution for the Prudent (and Tax Sensitive) Investor

Exchange Traded Funds (ETFs) are investments that offer many of the benefits of a mutual fund, but trade like an individual stock. ETFs generally represent a basket of securities, which vary based on the stated objective of the ETF. Some of the most popular exchange traded funds are based on certain indices including the S&P 500, Dow Jones, Nasdaq and the Russell 2000. Additionally, there are those that invest in a specific economic sector or even a specific country or region.

Advantages of ETFs

As with all investments there are pros and cons. Some of the advantages of utilizing ETFs in a portfolio are as follows:

• ETFs generally have very low operating expenses which rival even the cheapest mutual funds.

• Since most ETFs are a passive (non-managed) investment, they tend to be very tax efficient.

• Investors have the ability to make intraday trades.

• ETFs are transparent, allowing investors to see portfolio holdings on a daily basis.

Disadvantages of ETFs

Unfortunately, exchange traded funds do have several negatives including the following:

• Like stocks, there are commission charges with every transaction. This can make utilizing ETFs cumbersome and costly for people making systematic investments.

• Some of the more popular ETFs are very highly correlated with one another giving some investors a false sense of diversification.

• Since ETFs are unmanaged portfolios, stocks (or bonds) that are obviously poor investments are not eliminated from the ETF.

• Many exchange traded funds investing in stocks are market capitalization weighted. This means that the larger the company, the greater the weighting that company will occupy in the ETF.

• Certain types of exchange traded funds are not very tax efficient, so make sure you read the prospectus of any ETF in which you are considering.
  

While exchange traded funds can be fantastic tools for some investors, there may be alternatives that are more appropriate given your specific situation. For more information, please contact Chip Hymiller, CFP® or Erin Campbell, CFP®, CPA/PFS with Beacon Financial Strategies at (919) 321-8625.

About Beacon Financial Strategies

Beacon Financial Strategies is an independent financial planning, tax and investment advisory firm. Beacon works with clients on a consultative and objective basis to help them achieve their personal financial goals. Beacon professionals specialize in the following areas of financial planning: retirement feasibility planning, estate planning and coordination, tax minimization strategies, and wealth management services. For more information, visit Beacon's Web site at www.BeaconFinancialStrategies.com.