AN ETF is a basket of securities that you can buy or sell through a brokerage firm on a stock exchange.
It’s called Exchange-Traded because it’s traded on an exchange just like stocks. It’s a fund because money is pooled from many investors. This is unlike mutual funds, which are not traded on an exchange, and trade only once per day after the markets close.
1. Consider the track record
Stay away from these ETFs that:
• Don’t have $100 million of assets.
• Are thinly traded (less than $500,000 per day).
• Do not trade close to the true value of their stock holdings.
Find out if an index ETF’s performance been similar to the performance of the index it’s aiming to track. Measure an index ETF’s tracking error relative to its underlying index, look at the ETF’s most recent annual or semi-annual report. If there are significant periods where the ETF outperforms or underperforms the index, this could be a sign that the ETF manager is struggling to match the index portfolio.
2. Consider the structure
ETFs have different legal structures:
• Commodity ETFs that hold a physical commodity such as precious metals are usually structured as Grantor Trusts. Gains are taxed as collectibles at a rate of up to 28% currently, but the funds do not issue K-1 statements.
• Commodity ETFs that hold futures contracts (most commodity ETFs other than precious metals) are usually structured as Limited Partnerships. These funds report shareholders’ share of partnership income on Schedule K-1 instead of Form 1099 and are vulnerable to contango (when the future price of the commodity is higher than the current price). K-1s are more complex to handle on a tax return than 1099s, but professional tax preparers or well-informed individuals who do their own taxes should be able to handle K-1s correctly.
• ETFs that track indexes of the near-term futures contract are likely to perform worse than ETFs that track indexes that include longer-dated futures contracts.
3. Consider the firm
As with any investment, due diligence is important. Pick ETFs with strong companies behind them, just as you would with a mutual fund. Look for stable management with a clean record with regulators.
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Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation.
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He retired after 50 years of defending taxpayers audited by the IRS, EDD, BOE and other governmental agencies. He published a book on “How to Avoid or Survive IRS Audits.” Readers may email tax questions to [email protected].
