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  • ETFs have proven advantages and disadvantages, which help dictate the kind of investors they are best suited for.

    Benefits and risks of ETFs

    According to Lipper Inc., the average annual expense ratio for an ETF is 0.60% or $60 per year for every $10,000 invested. In contrast, the typical S&P 500 Index fund expense ratio, according to Lipper, was 0.58% ($58 per year for a $10,000 investment) as of May 2014.

    The difference owes largely to sharply lower operating costs on ETFs because most sponsors of ETFs provide little or no customer support.

    Another positive is that ETFs give you access to many kinds of indexes. There are ETFs for individual sector benchmarks, such as the Nasdaq Biotechnology Index; non-U.S. benchmarks, such as the MSCI South Korea Index; and the bond market, including the iShares Barclays Aggregate Bond Fund. ETFs allow investors to target very specific investment opportunities.

    ETFs are tax-efficient. Portfolios incur capital gains and a resulting tax liability when appreciated securities are sold. But sales of portfolio holdings in ETFs are infrequent. Like an index mutual fund, index-based ETFs are passively managed and have limited turnover.

    ETFs have an additional tax advantage in that they do not experience daily cash flows. Once a block of shares is being traded on the market, ETF sponsors only offer new shares (or redeem old ones) in large blocks to brokerage firms or other sizable shareholders. And when redeeming a block of shares, an ETF typically has the option of doing an in-kind trade, which transfers actual securities to the redeemer rather than cash. In-kind trades do not generate capital gains. ETF managers can use this opportunity to remove securities with a high tax liability, effectively allowing you to delay capital gains taxes until the final sale.

     
    Advantage Explanation
    Low fees Operation and management fees are typically lower than for index mutual funds.
    Trading flexibility Shares can be bought or sold at market prices at any time of the trading day. Investors can use stop and limit orders (if permitted by your broker), sell shares short (subject to exchange rules), or buy on margin (with borrowed money).
    Extensive market exposure Available ETFs represent an extremely broad variety of market benchmarks, including large-cap U.S. stocks, sector stocks, emerging markets, and more.
    Diversification An ETF is a single security that can represent a well-diversified portfolio of stocks or bonds.*
    Tax efficiency The structure of ETFs can significantly limit the potential for incurring taxable gains until the security is sold.

    *Diversification cannot assure a profit or protect against loss in a declining market.

    Despite their potential value, ETFs have risks and costs that you must be prepared for.

     
    Disadvantage Explanation
    Brokerage costs Trading into and out of ETFs incurs sales commissions and, possibly, other brokerage fees.
    Market pricing There is no guarantee that the market price of an ETF is the same as the market value of the ETF’s underlying securities.
    Limited portfolio strategy options Currently, most publicly available ETFs are passively managed and offer investors few opportunities to maximize gains or limit losses through portfolio strategy.
    Lack of support Many ETF sponsors provide limited customer support.

    The principal disadvantage is brokerage costs. Purchases and sales of ETFs trigger sales commissions and, possibly, other brokerage costs. When these fees are added to the total cost of the investment, no-load index funds, which have no sales charges, can become a less expensive alternative.

    Under ordinary circumstances, index-based ETFs carry the typical risks associated with any index fund:

    • Market risk — the chance that the market it invests in will decline
    • Opportunity cost — the possibility that other investments will perform better
    • Business risk — occurs when an individual holding falls and reduces returns for the entire portfolio
    • Tracking error — the chance that the fund's manager will do a poor job of tracking the performance of the benchmark

    Investors should be particularly aware of the risks involved in both leveraged ETFs, which are designed to magnify the returns of the index or benchmark they track, and inverse ETFs, which may allow investors to profit from a decline in the underlying index or benchmark. The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) warned investors that such funds are designed to meet their performance objectives on a daily basis only. Over longer periods, returns on leveraged and inverse ETFs may differ significantly from the underlying benchmark; for example, a leveraged ETF designed to double the daily return of an index might actually decline in value over a longer period even if the index records a gain.

    Because ETFs are subject to market supply and demand, they also carry the risk that their market value will deviate and trade at a discount to the actual value of the underlying securities. A variety of trading techniques are used to limit the amount of variation, but there is no guarantee that these mechanisms will work if the market experiences a significant disruption in a short period.

    Finally, the level of customer service (in the form of 800 numbers, websites, and customer service staff) varies among ETF sponsors and is often far less extensive than what is offered by mutual funds.

     
    Who Why
    Investors with large lump sums to invest The fewer trades you make (and the more assets you spread the brokerage fees across), the less you pay in brokerage costs and commissions.
    Buy-and-hold investors with a long time horizon The low fees on ETFs mean you keep more of your investment, especially if you don’t trade often.
    Sophisticated investors who like to manage their assets ETFs offer an ideal way for sophisticated investors to diversify their portfolios.

    ETFs are most appropriate for investors with long-term investment goals and a large lump sum to invest. The brokerage costs incurred on every trade make ETFs too costly for those looking to invest small sums or for those who wish to build their assets with frequent small purchases.

    In addition, sophisticated investors and large institutions can use the breadth of ETF offerings to target specific market segments in their portfolios.

    Investing via an ETF requires a certain amount of preparation, planning and awareness. For savvy investors, ETFs present an alternative to individual securities and mutual funds.

    Contact T. Rowe Price Brokerage to request a prospectus, which contains investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. To request a prospectus for an Exchange-Traded Fund or non-T. Rowe Price Fund, please call 1-800-225-7720.

    To open an account or for more information about T. Rowe Price or T. Rowe Price Brokerage, please call 1-800-638-5660.

    Leveraged ETFs can be complex and may carry substantial risk. Many leveraged and inverse leveraged ETFs are designed for short-term trading since they reset daily and seek to achieve their return objectives on a daily basis. Performance may differ from the performance of the underlying index and may not meet the performance expectations that may be suggested by their names. For more information, you should consult the website of the issuer of the ETF you are considering.

    T. Rowe Price Brokerage is a division of T. Rowe Price Investment Services, Inc., member FINRA/SIPC. Brokerage accounts are carried by Pershing LLC, a BNY Mellon company, member NYSE/FINRA/SIPC.

    Copyright 2013, T. Rowe Price Investment Services, Inc. All rights reserved.