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ETFs | Education

ETFs | Education

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What are ETFs?

Exchange-traded funds (ETFs) are investment vehicles that combine characteristics of both mutual funds and stocks. Each share represents a basket of securities like a mutual fund, but trades on an exchange like a stock.

How are ETFs similar to Mutual Funds?

  • ETFs represent ownership in a collection of stocks, bonds, and other investment types, offering investors a convenient way to achieve instant diversification.
  • ETFs can be actively or passively managed.

How are ETFs similar to Stocks?

  • ETFs can be bought or sold through a brokerage account, using a full range of order types (market, limit and stop). ETFs can even be traded on margin and can be shorted.
  • ETFs can be traded and are repriced throughout the day during open market hours.

What are some of the benefits of ETFs?

  • Because of their structure, ETFs can offer investors multiple benefits including lower costs, tax efficiency, transparency, flexibility, ease of access, and intraday liquidity.
  • However, buying and selling ETFs may be subject to paying brokerage fees. Market prices of ETFs can vary from their NAV.

Transactional differences between ETFs & Mutual Funds

The share creation/redemption process for ETFs helps to explain their ability to be “exchange traded” and drives the distinct difference in the buying and selling of an ETF versus a mutual fund.

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When investors buy mutual funds, they typically purchase shares directly from the fund sponsor. They likewise sell back (redeem) their shares to the fund company when they exit their investment.

The purchase and sale of mutual fund shares may force the fund manager to go to the capital markets to fulfill requests for shares or cash. This transaction can cause tax consequences for investors in that fund.

Example: Mutual fund investors rush to redeem shares in down markets, the fund may be compelled to sell portfolio securities to raise cash to meet redemptions. This selling of shares is considered a taxable event and can impact all remaining shareholders.

If portfolio securities are sold for a gain, a tax liability may be created, which can be passed through to non-redeeming investors.

In addition to fund generated capital gains. mutual fund investors will incur a capital gains tax liability if they personally sell their shares at a gain.

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Unlike a mutual fund, only authorized participants (APs) may transact directly with an ETF. APs are ordinarily large investment firms that have authorization to deal directly with the fund through a participant agreement with the fund sponsor. the process by which an AP interacts with the ETF is called the creation/redemption process.

APs will generally create and redeem shares "in-kind" with the fund, meaning that they exchange shares, not cash with the ETF. These cashless transactions are typically not taxable events and help make ETFs relatively tax efficient.

Example: as part of the creation process, an AP receives ETF shares in-kind and at net asset value (NAV) which can then be introduced to the secondary market where they are traded between buyers and sellers on an exchange similar to a stock.

Remember, selling your mutual fund or ETF shares at a a gain will trigger a taxable event.

Considerations for evaluating an ETF

Investors and financial intermediaries have many options to choose from in multiple categories including equities, fixed income, commodities, alternatives, and currencies. What are some things to consider in choosing the right ETF?

Strategy & Exposures

What is often most important when considering any investment is its fit within a particular portfolio. The objective and strategy of the investment as well as the exposures that it provides are often critical to the success and goals of the overall investment mandate. This level of due diligence should hold true for evaluating ETFs, especially now given the expansion of vehicle structures and enhanced complexity of strategies. More information can be found in each fund's prospectus.

Management Style

ETFs come in multiple management styles including passive, traditional active, scientific active, multi-manager active, and single and multi-factor smart beta strategies. Investors and financial intermediaries should evaluate which works as a desirable solution for themselves and/or their clients.

Manager Selection

Once the strategy and management style are chosen, it is important to select the right manager to execute the strategy. Evaluating for manager expertise, skill, and specialization is a critical component of the due diligence process.

Cost

Cost isn’t limited to an ETFs expense ratio. Items like trade commissions, internal and external bid/ask spreads, and premium/discount should also be considered when evaluating the total cost of ownership of an ETF.

Liquidity

ETF investors should not only consider the liquidity of the ETF itself, but also the liquidity of the underlying securities which impacts the internal trading efficiency of the portfolio.

Premium/Discount

The market price of an ETF is driven by forces of supply and demand and may deviate from the NAV of the portfolio. The creation and redemption mechanism of ETFs helps keep NAV and market prices aligned but ETFs can trade at a premium to NAV which can be an added cost. An important part of ETF due diligence is having a clear understanding of an ETFs premium/discount and what should be expected given market dynamics and the strategy and/or asset class.

There’s lots to consider when choosing an ETF. Performing proper due diligence when evaluating an ETF may go a long way towards your success as an ETF investor. Carefully read the prospectus of any investment prior to investing.

ETFs and Active Management

ETFs are no longer solely equated with passive management. Recognition that the ETF structure works well as a wrapper for many active strategies continues to be more widely accepted and adopted by investors.

The inherent cost, intraday tradability, ease of access, and potential tax benefits of the ETF structure have undoubtedly helped fuel the growth of actively managed ETFS.

Source: Morningstar Asset Flows, June 30, 2022

When evaluating an actively managed ETF, there are some important questions that we believe investors should consider, including…

  • Fund Objective – Does your investment mandate align with the objective of the ETF strategy?
  • Manager Skill – Does the manager have proficiency and expertise in the area in which you will be investing?
  • Risk Management – Does the strategy have risk provisions in place?
  • Liquidity – Does the strategy account for liquidity of the underlying holdings?
  • ETF Vehicle – Does the ETF structure act as a desirable vehicle for accessing the strategy?

Trading ETFs

ETFs can be bought or sold through a brokerage account, using a full range of order types (market, limit and stop). ETFs can even be traded on margin and can be shorted.

Because of this feature of ETFs, we believe there are actions to consider when trading an ETF.

  • Consider using “limit” orders instead of “market” orders.
    Limit orders allow for the investor to buy a security at no more (or to sell it at no less) than a specific price which provides for more control of price execution versus a market order.
  • Seek to avoid trading at either the market open or close.
    At or near the market opening or close is when bid/ask spreads tend to be at their widest and when prices can be volatile. It is typically preferable to avoid trading ETFs during that time.
  • For larger orders, consider reaching out your brokerage firm or the ETF issuer for guidance.
    ETF issuers and brokerage firms have relationships with liquidity providers who can be leveraged to help facilitate larger trades and provide additional sources of liquidity. Often, leveraging the creation/redemption mechanism of the ETF is an option for facilitating larger trades.

With ETFs, redemptions may be limited and often commissions are charged on each trade. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value.

Market Order

A market order is an instruction by an investor to a broker to buy or sell stock shares, bonds, or other assets at the best available price in the current financial market.

Limit Order

A limit order is a type of order to purchase or sell a security at a specified price or better. For buy limit orders, the order will be executed only at the limit price or a lower one, while for sell limit orders, the order will be executed only at the limit price or a higher one. This stipulation allows traders to have more control over the prices they trade.

Stop Order

A stop order is an order to buy or sell a security when its price moves past a particular point, ensuring a higher probability of achieving a predetermined entry or exit price, limiting the investor's loss, or locking in a profit. Once the price crosses the predefined entry or exit point, the stop order becomes a market order.

Margin Buying

Buying on margin occurs when an investor buys an asset by borrowing the balance from a bank or broker.

Short Selling

Short selling is an investment or trading strategy that speculates on the decline in a security's price.

ETF Liquidity

ETF liquidity refers to the relative trading volume and bid/ask spreads of both the ETF itself (secondary market) and its underlying holdings (primary market). In general, the greater the trading volume, the more liquid the security.

Liquidity Provider

ETF liquidity provider’s serve as mediators between brokerage companies and investors. They are responsible keeping pricing and markets efficient.

Investing in Harbor’s ETFs

Any information needed to identify Harbor’s ETFs can be found on our ETF product pages. Harbor believes that active ETFs are a good way to access these compelling investment strategies while potentially being a tax-advantaged investment. All fund materials, including performance information, factsheets, prospectuses, etc. are available on the ETF product pages. It is important to note that investors should consult a financial professional, an attorney, or tax professional regarding the investor’s specific situation.

Our ETFs are available through various channels including broker-dealers, investment advisers, and other financial services firms, including Envestnet, Fidelity, Pershing, Schwab, TD Ameritrade and more.

Please note that you cannot buy Harbor ETFs directly through Harbor Capital Advisors, Inc.

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Information and Disclosure

Investing involves risk, principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value.

Shares are bought and sold at market price not net asset value (NAV). Market price returns are based upon the closing composite market price and do not represent the returns you would receive if you traded shares at other times.

ETFs are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are generally minimized for the holder of the ETF. An ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying portfolio. However, capital gains tax may be incurred by the investor after the ETF is sold.

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Harbor Funds Distributors, Inc. is the Distributor of the Harbor Mutual Funds.
Foreside Fund Services, LLC is the Distributor of the Harbor ETFs.
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Investing involves risk and the potential loss of capital.

Investors should carefully consider the investment objectives, risks, charges and expenses of a fund before investing. To obtain a summary prospectus or prospectus for this and other information, click here or call 800-422-1050. Read it carefully before investing.

All trademarks or product names mentioned herein are the property of their respective owners. Copyright © 2024 Harbor Capital Advisors, Inc. All rights reserved.