What is the ETF rule?
The ETF rule is a measure taken by the Securities and Exchange Commission that provides relief for funds waiting in line for approval. The rule creates a faster track for funds by removing certain previous requirements.
For most ETFs, selling after less than a year is taxed as a short-term capital gain. ETFs held for longer than a year are taxed as long-term gains. If you sell an ETF, and buy the same (or a substantially similar) ETF after less than 30 days, you may be subject to the wash sale rule.
You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.
ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.
ETFs don't have minimum investment requirements -- at least not in the same sense that mutual funds do. However, ETFs trade on a per-share basis, so unless your broker offers the ability to buy fractional shares of stock, you'll need at least the current price of one share to get started.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
In order to withdraw from an exchange traded fund, you need to give your online broker or ETF platform an instruction to sell. ETFs offer guaranteed liquidity – you don't have to wait for a buyer or a seller.
- ProShares Bitcoin Strategy ETF (BITO)
- Invesco QQQ Trust (QQQ)
- Vanguard Information Technology ETF (VGT)
- VanEck Semiconductor ETF (SMH)
- Invesco S&P MidCap Momentum ETF (XMMO)
- SPDR S&P Homebuilders ETF (XHB)
- Invesco S&P 500 GARP ETF (SPGP)
How do ETFs work for dummies?
Basic trading choices for ETFs or stocks
You place an order with your broker or online to buy, say, 100 shares of a certain ETF. Your order goes to the stock exchange, and you get the best available price. Limit order: More exact than a market order, you place an order to buy, say, 100 shares of an ETF at $23 a share.
- Interest distributions if the ETF invests in bonds.
- Dividend. + read full definition distributions if the ETF invests in stocks that pay dividends.
- Capital gains distributions if the ETF sells an investment. + read full definition for more than it paid.
If you're looking for an easy solution to investing, ETFs can be an excellent choice. ETFs typically offer a diversified allocation to whatever you're investing in (stocks, bonds or both). You want to beat most investors, even the pros, with little effort.
ETF | Ticker | Assets Under Management (AUM) |
---|---|---|
Vanguard S&P 500 ETF | (NYSEMKT:VOO) | $435.2 billion |
Invesco QQQ Trust | (NASDAQ:QQQ) | $259.6 billion |
Vanguard Growth ETF | (NYSEMKT:VUG) | $118.8 billion |
iShares Core S&P Small-Cap ETF | (NYSEMKT:IJR) | $79.8 billion |
Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification.
- Open a brokerage account. You'll need a brokerage account to buy and sell securities like ETFs. ...
- Find and compare ETFs with screening tools. Now that you have your brokerage account, it's time to decide what ETFs to buy. ...
- Place the trade. ...
- Sit back and relax.
If you hold these investments in a tax-deferred account, you generally won't be taxed until you make a withdrawal, and the withdrawal will be taxed at your current ordinary income tax rate. If you invest in stocks and bonds via ETFs, you probably won't be in for many surprises.
Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.
Watch the wash sale rule
The tax law does not define substantially identical security, but it's clear that buying and selling the same security meets the definition. For example, if you sell shares in the XYZ ETF at a loss and buy it back within the wash sale period, you cannot take the loss now.
Specifically, a fund is prohibited from: acquiring more than 3% of a registered investment company's shares (the “3% Limit”); investing more than 5% of its assets in a single registered investment company (the “5% Limit”); or. investing more than 10% of its assets in registered investment companies (the “10% Limit”).
What is the 3% limit on ETFs?
Under the Investment Company Act, private investment funds (e.g. hedge funds) are generally prohibited from acquiring more than 3% of an ETF's shares (the 3% Limit).
As a retail investor, you can't buy and sell the same stock more than four times within a five-business-day period. Anyone who exceeds this violates the pattern day trader rule, which is reserved for individuals who are classified by their brokers are day traders and can be restricted from conducting any trades.
Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.
There are many ways an ETF can stray from its intended index. That tracking error can be a cost to investors. Indexes do not hold cash but ETFs do, so a certain amount of tracking error in an ETF is expected. Fund managers generally hold some cash in a fund to pay administrative expenses and management fees.
The managers will sell all holdings in the fund, settle other obligations and divvy up the balance among remaining shareholders. The price per share from liquidation could differ from the fund's last trading price, so be aware of this risk.
References
- https://www.smartaboutmoney.co.za/saving-and-investing/exchange-traded-funds/how-quickly-can-i-get-my-money-out-of-an-etf/
- https://www.bankrate.com/investing/stocks-vs-etfs/
- https://www.schwab.com/learn/story/primer-on-wash-sales
- https://investor.vanguard.com/investor-resources-education/taxes/how-mutual-funds-etfs-are-taxed
- https://www.fool.com/investing/how-to-invest/etfs/
- https://www.fidelity.com/learning-center/investment-products/etf/risks-with-etfs
- https://www.schwab.com/etfs/understand-etfs
- https://www.investopedia.com/financial-edge/0910/the-two-hour-a-day-trading-plan.aspx
- https://www.pillsburylaw.com/images/content/3/2/v2/3201/C-S-Advisory-07-22-2010-II.pdf
- https://www.investopedia.com/articles/exchangetradedfunds/09/etf-out-of-business.asp
- https://www.nerdwallet.com/article/investing/exchange-traded-fund-closure
- https://www.investmentfundlawblog.com/resources/investments-by-funds/investments-investment-companies/
- https://www.dummies.com/article/business-careers-money/personal-finance/investing/investment-vehicles/etfs/investing-in-etfs-for-dummies-cheat-sheet-207441/
- https://www.fidelity.com/learning-center/investment-products/etf/drawbacks-of-etfs
- https://www.fool.com/investing/how-to-invest/etfs/etfs-to-buy/
- https://www.getsmarteraboutmoney.ca/learning-path/etfs/how-exchange-traded-funds-etfs-work/
- https://www.nerdwallet.com/article/investing/how-to-invest-in-etf-exchange-traded-fund
- https://www.fidelity.com/learning-center/investment-products/etf/tax-rules-for-losses-etfs
- https://www.trackinsight.com/en/education/how-many-etfs-should-you-own
- https://www.investopedia.com/articles/investing/121515/why-3x-etfs-are-riskier-you-think.asp
- https://www.investopedia.com/financial-edge/0113/7-easy-to-understand-etfs-to-replace-a-savings-account.aspx
- https://money.usnews.com/investing/articles/best-etfs-to-buy
- https://www.schwab.com/learn/story/etfs-and-taxes-what-you-need-to-know
- https://www.investopedia.com/articles/exchangetradedfunds/08/etf-taxes-introduction.asp