There is no shortage of financial marketing to executives, which can make it difficult to make a truly educated decision when it comes to the investment vehicles you choose to utilize. Exchange-traded funds (ETF) are relatively new investment vehicles compared to mutual funds, for example, but just like restricted stock units in relation to the more seasoned employee stock options, ETFs are gaining traction and favor among C-suite-level investors.
To better understand an exchange-traded fund, you simply need to say it backward: “fund-traded exchange.” It is a fund that is traded on the open exchange, in our case, the U.S. stock exchange. Unlike a traditional mutual fund, an exchange-traded fund tracks a particular index or holds specific types of assets, much like an index fund. An ETF could track bonds, commodities, the S&P 500, or other stock indexes. You can even find ETFs that offer exposure to margin calls, short sales, and stock options. Executives considering investing in exchange-traded funds will find that they can be effective asset allocation tools to spread risk across multiple assets, and even multiple asset classes. Here’s a closer look at the pros and cons of investing in exchange-traded funds.
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Benefits of Investing in Exchange-Traded Funds
One of the largest advantages of investing in exchange-traded funds is tax efficiency. This is due mainly because ETFs are passively managed. In fact, many mutual funds experience close to and even over a 100% turnover rate while many ETFs are around a 10% turnover rate. This means that mutual funds could actually sell all of their holdings within a given year, which can generate lots of capital gains taxation. Meanwhile, ETFs tend to minimize sales of holdings throughout the year, keeping their turnover rate and tax bill low.
There are certainly other benefits to investing in an ETF as well. Let’s take a look at some of the positive aspects involved in investing in an exchange-traded fund.
- Because ETFs are passively managed, the fees are usually considerably lower than actively-managed mutual funds.
- The diversification is greater than buying individual assets, such as a stock or bond.
- ETFs are traded on the stock exchange, so their price fluctuates throughout the day. This is a reason why ETFs are considered to have better liquidity than a mutual fund that tracks the same asset or index.
- Another benefit of this type of investment is the favorable tax treatment it can offer due to capital gains being held within the fund rather than being passed on to shareholders, which is not the case for mutual funds.
While ETFs bolster some impressive perks when it comes to investing, they have their share of drawbacks as well. Let’s explore those in more detail.
Drawbacks to Investing in Exchange-Traded Funds
No matter what investment vehicles you choose to utilize to achieve your financial goals, there will always be positive and negative aspects. ETFs are no different. It’s important to explore the drawbacks to ensure that you can make the best decision possible for your financial situation before investing in exchange-traded funds. Those include:
- Due to the passive investment nature of an exchange-traded fund, you could find yourself missing out on some trends and opportunities for profit by sticking with a passive ETF platform.
- If your main objective is yield, then you might find that ETFs focusing on dividends tend to pay out less and cost more than owning individual stocks, due to the diversification they are striving for.
- To invest in an ETF, you may need to first sell your concentrated stock position or other holdings, which could cause a large capital gains taxable event.
- An ETF does not allow you to roll your money into the fund without first converting it to cash, which can also bring in market timing factors as far as when you sell your stock or other positions and when you purchase the ETF shares.
Now that we’ve covered the benefits and drawbacks of investing in ETFs, there is one area I’d like to explore a bit deeper because it’s an issue many of our executive clients face: Are ETFs a good investment strategy for diversifying a portfolio of concentrated stock?
ETFs and Diversification
As a top-level executive, you may have accumulated a concentrated stock position in one or more stocks through employee stock options or other forms of equity compensation. However, “putting all of your eggs in one basket,” as the saying goes, is not a great long-term strategy if you are looking to avoid large risk exposure concerning your personal investment assets. While ETFs can spread risk across numerous assets and multiple asset classes, it would require the sale of your concentrated position, therefore negating some of its benefits with capital gains taxation.
That’s why the first diversification solution we usually explore for concentrated stock positions is an exchange fund, not an exchange-traded fund. An exchange fund is typically set up by executives with the help of advisors to pool together concentrated stock positions of each executive/investor with the end goal of diversification for the group.
Here’s an example to illustrate the difference between the two:
An executive has $1 million of stock to invest, with a basis of $100,000. If he were to invest in an ETF, he would be required to pay capital gains tax on $900,000. That executive would lose at least 30% or more by doing so.
However, if he chose to invest in an exchange fund, he could invest his concentrated stock position into the fund and receive shares equal to $1 million without paying capital gains tax until he chooses to sell his shares. Most exchange funds are fully diversified with around 50 stocks or so. The major benefit of an exchange fund over an ETF is that the executive’s entire million dollars goes to work for him and he doesn’t give up $300,000 in capital gains tax because he has to sell the stock and reinvest the difference in an ETF.
Weigh Exchange-Traded Funds Pros and Cons with an Expert
The many benefits of exchange-traded funds make them a unique solution for asset allocation in that they can instantly spread your investment and risk across many assets (such as a particular stock index) and even across different asset classes (like a fund that finds yield in stock, bonds, MLPs, and so on). Of course, there are drawbacks to consider, and if you’re an executive faced with a concentrated stock position, there may be an even better investment vehicle out there. That’s why it’s important to seek out an experienced financial advisor who specializes in helping top-level executives choose the most effective investment options. In doing so, you can feel confident you have a long-term strategy in place to minimize risk, as well as taxation, through executive-level solutions.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for portfolio asset allocation.
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