When you invest in a regular mutual fund after it has had a gain, the price of the fund shares reflects those gains. Thus, when you buy, you are paying for those gains. The fund will distribute that gain to you (return your own money), causing the shares to drop in value from what you paid for them. You then have to pay taxes on that gain even though you did not participate in it (you are actually paying taxes on the return of your own investment capital because you did not own the shares until after the gain was made). ETFs are not like this. With ETFs you're far less likely to get any capital gains distributions on which you have to pay taxes because most ETFs do not have active managers. In that regard, they tend to resemble indexes and index funds. Their portfolios become relatively static after the managers buy stocks representing particular indexes or sectors. For example, Barclay's Global Investors, which has many ETFs they call iShares, reported "zero year-end capital gains for [its] entire fund family" in one year we checked. However, the fact that the components that make up most ETFs rarely change does not keep an individual from changing the ETF components of his portfolio as different sectors gain and lose strength, just as he would make changes in a portfolio of ordinary stocks. Of course, taxes would have to be paid if an ETF were sold at a profit, just as with any stock. Like ordinary index funds, ETFs boast ultra-low expenses and little opportunity for the big players to cheat or take unfair advantage of little players. Individuals can buy or sell an ETF anytime the market is open, so if a person decides to bail out at 3:13 p.m., he can be out before 3:14 p.m. The procedure for doing this is identical to the procedure for selling any stock.

Though many mutual funds and ETFs are managed similarly during "rational" markets, ETFs have a potential advantage when investors are suddenly overcome by fear. ETFs do not have to liquidate portfolio positions as shareholders redeem shares. Therefore, ETFs are better situated to ride out a wave of selling without incurring damage to the structure of their portfolios (it's also not necessary for ETF managers to keep large amounts of cash available to meet the potential redemptions of frightened shareholders). Furthermore, because they are traded on an exchange like ordinary stock, they cannot be affected by the dishonest behavior of other investors in the same pooled account as is possible in most ordinary mutual funds nor by special treatment given to a few at the expense of the many. ETFs also are not subject to the illegal form of market timing that once darkened the reputations of so many mutual funds. Like traditional open-end mutual funds, ETFs distribute their earnings to shareholders in two ways. First, income dividends from interest or stock dividends are passed through to shareholders, net of expenses. Second, realized capital gains distributions (net of realized capital losses) are passed through to shareholders--usually once a year in November or December.

ETFs are completely free from scandal. The very structure of ETFs makes it extremely unlikely that investors would ever be affected by any fraudulent behavior on the part of fund managers. They are flexible investments, charge no load, and have a very low expense ratio in comparison with similar no-load mutual funds of the "standard" variety.

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com

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