What is an ETF and how does it work?

Track record: Assess an ETF’s track record to evaluate whether it has met its performance objective. In general, you should review at least one year of actual performance history, as most ETFs should perform similarly to the underlying benchmark index. You should also review how the benchmark index itself has changed over time, as this can cause the ETF to perform differently.

Low expenses: Many ETFs have lower expenses because they’re passively managed. Passively managed ETFs representing a certain asset class tend to be similar, so costs can be an important difference. The following represents a general guideline for ETF expenses:

Source: Morningstar

The expense ratio measures what percentage of a fund’s assets are used to pay for the operating and administrative expenses of that fund, which reduce an investor’s return. The expense ratio of a particular ETF may be higher or lower than the guidelines noted in the chart above. You should carefully review the prospectus for the ETFs expense ratio.

More than $100 million in assets under management (AUM): Hundreds of ETFs have been launched in the past few years, and many still have marginal assets under management. Edward Jones suggests investing in ETFs that have at least $100 million in AUM, which is the level we believe is helpful to sustain their operations.

Share price premium or discount relative to net asset value (NAV): The NAV of the fund’s underlying holdings primarily determines an ETF’s price, along with the supply of and demand for shares in the market. This may cause an ETF to trade at a premium or discount to its NAV. Edward Jones suggests seeking funds trading at minimal premiums or discounts to NAV. Most broad-based ETFs trade within 2% of the fund’s NAV – although this spread could widen in periods of market volatility. The premium or discount could also be more significant for more narrowly focused ETFs.

Additional Considerations

  • Tax implications: An ETF’s holdings may affect capital gains or dividend distribution taxes. While most ETFs are legally structured as open-ended funds, meaning there is no limit to the number of shares the fund can offer, some may not be. Certain ETFs may generate a K-1 tax form, which may be undesirable for some investors. You can find the details on fund structure and tax implications in an ETF’s prospectus. Talk to your qualified tax professional about your situation.
  • Underlying holdings: Understanding an ETF’s underlying holdings can help identify significant weightings to individual securities, industries, sectors or geographic locations, which may indicate the ETF is not as diverse as it seems. Knowing how the ETF is invested can lead to fewer performance surprises.
  • How to invest in ETF funds: Like stocks, ETFs trade on an exchange. This means you can place different types of orders, and the time of day you place an order can affect the price you receive. ETF prices may be more volatile near the market’s opening and closing. Talk with your financial advisor to understand order types and their implications.

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