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1.
ETFs have special tax-related advantages relative to mutual funds. Which statement is incorrect?
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ETF investors must pay a tax every time they invest in an ETF. ETF investors do not need to pay a tax each time they invest in an ETF. Meanwhile, it is indeed true that redemptions by large ETF investors are paid in kind, protecting shareholders from taxable events, and it is also true that most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions. Finally, its also true that regular mutual fund investors can suffer when mass investor selling occurs. This is because large investor selling can drive mutual fund portfolio managers to have to sell stocks in order to meet redemptions, and that act can result in mutual funds needing to make taxable capital-gains distributions to shareholders.
2.
What kind of investor probably should choose a more expensive open-end mutual fund over an ETF?
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A small investor who invests regular sums of money. Small investors who invest regular sums of money are exposed to high transaction costs in the form of regular brokerage fees. These transaction costs usually eat into investors overall performance. As a result, investors who invest regular sums of money probably are better off going with an open-end mutual fund, even if its price tag is higher. Day traders may still be better served with ETFs, given ETFs stock-like qualities and given the fact that day traders move in and out of positions throughout the day. At the same time, day traders are at risk of incurring high transaction costs as well, although we assume that day traders frequent moves can generate returns that cover those transaction costs and the high short-term capital gains rates.
3.
Why are ETFs expense ratios generally lower than those of open-end mutual funds?
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All of the above. ETFs indeed can and do passively track the performance of virtually any kind of index, with very few actively managed ETFs currently trading. ETF providers also dont have to manage hundreds of separate customer accounts or need to staff call centers, and they dont need to pay active portfolio managers the large salaries that mutual fund companies do. Finally, ETFs do indeed trade on an exchange, meaning that transactions occur directly between investors.
4.
What is the best way for an investor to invest in a highly focused ETF?
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To be contrarian, and to not chase whats been hot recently. The ETF universe has literally hundreds of ETFs that focus on a single market sector, industry or geographic region. However, too often, by the time a hot-performing market segment catches investors eyes, that segment is about to cool down -- at least, in the short term. Unfortunately, investors often pursue those corners of the market at precisely the wrong time. As a result, investors should not necessarily invest in focused ETFs that have attracted significant recent investor interest.
5.
Exchange-traded funds _______ make capital-gains distributions.
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Do. They simply do so less often than mutual funds do.