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ETFs are hot but can be confusing. Unclog your ETF brain here

By Dian Vujovich

Investors appear to love ETFs. There are now about 1200 of them around and not all worth investing in, mind you. Nonetheless, in April assets into these buckets of securities that trade like stocks grew by $1.14 trillion. That means over $22 billion flowed into them in April, according to data from the National Stock Exchange.

Hot or not, they can be tricky to understand.

To that end, the pros at Morningstar have answered some of the most common questions received from their readers. Below are a few of them with abbreviated answers. You can read the full text of the Q&A’s at:

Till then, here goes:

Q: Is it a good idea to use ETFs in IRAs or 401(k)s?

A: There is a downside to investing in ETFs in a tax-deferred account to which you make regular contributions. When you buy and sell an ETF, you incur a brokerage fee. If you make contributions on a biweekly basis, those brokerage fees can pose significant drag on returns in the long run. That said, a number of brokerage platforms offer commission free trades for certain families of ETFs, so you should check your plan.

Q: What are the tax advantages of the ETF structure?

A: For ETFs, the aforementioned share creations and redemptions are done “in-kind.” That is to say, that the fund provider exchanges ETF shares for a basket of its underlying constituents, instead of cash. The fund is thus able to avoid passing taxable capital gains to the investors.

There are instances, however, like portfolio rebalancing or index reconstitution, that the ETF must sell its underlying securities on the open market. These sales can garner taxable capital gains, which will inevitably be passed through to shareholders. Fortunately, there is a mechanism in place that serves to minimize such taxable gains.

Q: How often do indexes rebalance or reconstitute, and do ETFs have the ability to add or subtract from their index at will?

A: Each index has a unique set of protocols, but generally speaking, most index families rebalance quarterly or annually.

Q: Can you keep commodity ETFs in a retirement account?

A: You can certainly hold commodity-focused exchange-traded products in retirement accounts. The 60/40 taxation of LPs has led many to consider holding them in tax-deferred accounts such as IRAs. Because an IRA is not subject to capital gains taxes until withdrawal, the 60/40 rule won’t apply. The account structure allows investors to defer taxes on interest income until withdrawal as well.

Again, to read all questions and answers cut and paste the following address: http://news.morningstar.com/articlenet/article.aspx?id=380883

To read more articles, please visit the column archive.

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