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ETF Investors' Burning Questions

Answers to three of the questions that most commonly come up from advisors.

Scott Burns, 03/31/2010

ETFs are one of the fastest growing areas in the investing eco-system. As with any product undergoing such tremendous growth, the questions are multiplying at a rate almost as fast as providers can launch new ETF products. While new investors in ETFs will always have many of the same basic questions, the ever increasing complexity of ETF offerings often leave even experienced investors scratching their heads.

Sitting at the nexus of where products meet advisors, Morningstar's ETF research team is in the unique position to field questions first hand from financial advisors. We address these issues in our commentary--especially through Morningstar's ETFInvestor newsletter. This monthly publication is the ETF research team's "journal of record" and we consistently provide thought provoking and industry shaping features. Often times, the topics we cover are the result of the open communication that we enjoy with our subscribers. They ask and we answer.

Invariably, every year a few questions come to dominate the ETF investing world. In 2008, ETN credit risk was at the top of everyone's worry list. In 2009, the headline makers were leveraged and inverse ETFs and commodity-futures tracking products. Just as we provided insightful and timely analysis on these issues, we've scanned the landscape for 2010 and collected three of the questions that most commonly come up from advisors so that you can minimize any adverse investing experiences.

It is no surprise that in the first half of the year the nuances of ETF tax treatment continue to trip up advisors. ETFs in general are very tax-efficient vehicles due to the ability to create and redeem shares, saving the investor from the taxman until he or she chooses to sell the fund. However, that tax-efficiency doesn't carry over to ETFs that hold securities that aren't very tax efficient themselves.

The general rule of thumb we use is that as far as the IRS is concerned the ETF is a look through vehicle. That means that if the fund holds physical precious metals (such as SPDR Gold GLD) gains on any sale of the fund will be taxed as a collectible (ordinary income rates, capped at 28%) just like if you held the gold. Funds that hold futures contracts and other financial instruments such as most commodity-futures tracking funds, leveraged ETFs and inverse ETFs will be taxed as the underlying futures would be tracked. That's a not so tax-efficient 60%/40% split between long-term and short-term gains, regardless of how long you hold the fund. On top of that, you need to mark your gains or losses in these funds to market at the end of the year and pay taxes on that. PAGEBREAK

Those are the biggest areas that still trip up advisors, but the message as always is "know what you own" followed by "and know how it will be taxed."

One of the truly hot-button questions among ETF users is "how liquid does an ETF need to be in order for me to buy it?" The fact that ETFs trade on the exchange and can be transacted throughout the day is one of the great features of these products. However, with that flexibility comes the need to understand the mechanics of securities trading--no different than you would for a stock or bond.

An ETF that doesn't have much liquidity is much like a low-float stock or a small-cap stock. You would never want to put a market order out for those types of securities because the order book is so thin that the bid-ask spread on the fund could pop as much as 500 basis points on you as your order gets filled. Rather, we recommend that you use limit orders for all but the most liquid of ETFs. Since many advisors are purchasing ETFs across all their clients accounts in model portfolios, the size of their trades can add up to some very large trades. In that case, the best practice is to work with a liquidity specialist either at your execution platform or with the ETF provider.

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