Exchange-traded funds (ETFs) versus mutual funds
This article provides information about low cost ETFs, which account for only a few percent of the thousand plus ETFs and other exchange-traded products (ETPs) available to US investors. This article covers certain topics related to ETFs that are important to the investor who intends to use very low cost ETFs as an alternative to very low cost, no load mutual funds, when implementing a broadly diversified, passive, low tax, low effort, long-term buy-and-hold-and-hold-and hold investment strategy.
Low cost mutual funds and low cost ETFs are largely interchangeable. Either one or the other or some combination of the two will do. The commonality and interchangeability of ETFs and mutual funds is derived from an investor’s commitment to choose only very broadly diversified and very low cost investment funds of either type. At the low cost and very broadly diversified end of the investment fund product spectrum, either form of investment fund can serve the needs of the passive, long-term investor.
There have been long-running and generally self-interested financial industry arguments about the structural merits and demerits of mutual funds versus ETFs. These arguments are largely canards, as are so many other supposed “debates” about investing and investment products. The financial and investment industry perpetuates “debates,” whenever there is enough variability in results to enable self-interested denial or twisting of objective research evidence.
With mutual funds and ETFs, their differences and supposed advantages or disadvantages really only manifest themselves, when a sub-optimal investment strategy is attempted using either investment fund vehicle. Differences between ETFs and mutual funds can show up in less-diversified, higher cost, more active, higher turnover investment strategies. However, then the problem is not the comparative structure of the investment fund vehicle, but the lousy, sub-optimal strategy that deviates from a passive index investment strategy.
Whenever you decide to cut your investment costs to the bone, of necessity, you must choose from among broadly diversified, passive, index fund investments. Passive index tracking strategies are the only strategies that can be implemented cheaply and economically by an investment fund company. Passive index tracking strategies are the only fund strategies that can be priced very low in terms of the fees, costs, and taxes that the investor must pay directly or indirectly. Only if an investment fund operates very efficiently can it offer very low fees and be competitive.
At the highly efficient, low fee, low cost end of the investment fund product spectrum, index mutual funds and index ETFs become largely interchangeable. Both types of funds track the same passive, diversified indexes and both need to attract substantial assets to operate efficiently.Investors are cost sensitive and will direct their assets to lower cost vendors. The only way for vendors to be profitable is to run highly efficient operations, because the investors they attract refuse to pay high fees with no assurance of superior performance. With either low cost mutual funds or low cost ETFs, investor clientele have given up on the active-management shell game and are not attracted by ephemeral performance charts and stars. The just want low fees, low costs, and low taxes.
What are exchange-traded funds (ETFs) and exchange-traded products (ETPs)?
Structurally, ETFs are not as simple as mutual funds. This introduction points out a few things that you should pay attention to with ETFs. First, ETFs are a subset of the more general category of exchange-traded products (ETPs). To avoid, a longer discourse on ETFs and ETPs here, look at these two Wikipedia pages. If you have an interest and would like a starting point for your research, these Wikipedia pages are a place to start:
http://en.wikipedia.org/wiki/Exchange-traded_product
http://en.wikipedia.org/wiki/Exchange-traded_fund
This article overviews some aspects of ETFs that are important in a decision about whether you might choose low cost no load mutual funds or/and low cost ETFs to implement a long-term, passive index investment strategy. Nevertheless, this introduction simply cannot offer a comprehensive treatment of the subject of ETFs and the broader category of ETPs. A proper treatment of ETFs/ETPs would be a thick book in itself.
You should be aware of these aspects of ETFs/ETPs. If you do not feel that you know enough about these topics and other features of exchange-traded products, you should do your research before investing in any exchange-traded product or ETF.
- ETFs/ETPs trade on the securities markets “just like” stocks. They have a most recent trading price and a price history. Prices fluctuate, and there is a variable bid-ask spread. The bid-ask spread is an important additional cost factor to consider, since the trading spread is often much wider than you might expect. ETF bid-ask spreads increase with smaller and less liquid ETPs and with higher overall market volatility.
- The largest ETFs with high daily trading volume (“liquidity”) often, but not always have bid-ask spreads that are under .1% or even .05% of the price per share. However, spreads on other smaller and less liquid ETFs – which are the majority of ETFs – can have noticeably wider spreads, sometimes routinely over 1% of share price and even far higher.
- ETF bid-ask trading spreads are an important subject that you should not gloss over or ignore. If you do not know how to control your total ETF trading costs, then just buy very low cost no load index mutual funds directly from a mutual fund company. You get the end of day net asset value price per share like very one else, and professional mutual fund traders manage the necessary trading efficiently.
- In addition to a variable bid-ask trading spread, ETFs also may trade at a fluctuating discount or premium to the value of the underlying assets defined by the fund’s index. The sizes of discounts and premiums are limited by trading arbitrage activities among professional traders who attempt to profit through the ETF share creation and redemption process. ETF discounts and premiums tend to increase with smaller and less liquid ETPs and with higher overall market volatility. Like the bid-ask trading spread, ETF discounts and premiums may be larger than you might expect.
- Wide discounts and premiums are particularly a problem with bond ETFs. Just because bond ETFs trade like stocks, they do not magically overcome the high costs, complexity, and opaqueness of bond market trading. Instead, they just shift them, and their underlying existence is manifested in discounts and premiums.
- Particularly during market turmoil when there is a significant imbalance in buying and selling demand, bond ETF discounts, premiums, and their fluctuations can be stunning.
- JNK (SPDR Barclays Capital High Yield Bond) and HYG (iShares iBoxx $ High Yield Corporate) are two high yield (junk) bond funds have the lowest expense ratios in their category and at this writing trade with a relatively narrow discount or premium. Combined they hold about $16 Billion in assets.
- Despite being large in assets and having high trading volumes, these funds were not immune to widening discounts and premiums in shorter periods. In late 2008, HYG swung from a discount of 7.9% to a premium of 12.7% in two months. In early 2009, JNK had a 9+% premium flip over to a 2.5% discount within two weeks. During the municipal bond mini-panic in the fourth quarter of 2010, most municipal bond ETFs traded at a discount to their asset value throughout the quarter. (Michelle Knight, “Rethinking Bond ETFs”, Financial Advisor Magazine, August 2011, p. 85-86)
- Sometimes ETFs/ETPs are described as mutual funds that trade like stocks and that can be traded intra-day on a stock exchange. Nevertheless, ETF and mutual fund pricing, purchase, and sale processes differ significantly.
- “Open end” mutual funds, which is what most mutual funds are, have a once-a-day, end-of-day settlement, share pricing, and purchase/sale process. The mutual fund company manages all of this internally.
- Some mutual funds allow retail investors to do business directly with the fund company, while others require you to use an intermediary. You can buy most mutual funds through a full service broker, discount broker, or other financial advisor. However, this does not mean that the mutual funds themselves trade on an exchange. It just means you are paying an intermediary for this service. Often these intermediaries steer you into significantly more expensive and more active funds that provide higher compensation to the advisor. The research literature indicates that these intermediaries have no special knowledge or skill in selecting funds, and thus you may be paying dearly, if you use an intermediary to buy investment funds.
- Mutual funds internalize the costs of market trading associated a) with management decisions about composition of the overall portfolio and b) due to net investor inflows and outflows related to the purchase and sale of mutual funds. Like mutual funds, ETFs retain the trading costs associated with managing the overall portfolio. However, ETFs externalize trading costs related to investor buying and selling.
- Thus, existing and inactive buy-and-hold ETF shareholders are insulated from the trading actives of other investors. ETF traders bear their own trading costs. Often, this is promoted as a relative virtue of ETFs in comparison with mutual funds, but it is only a virtue if the ETF investor trades carefully and economically and holds his or her position for a long time to amortize the buying and selling trading costs that are incurred personall
- Unfortunately, the data indicate that ETF ease-of-trading and the supposed low cost, “under ten bucks” trading via discount brokers can induce many individual “retail” investors to trade frequently. With higher trading frequency, trading costs can mount very rapidly on a percent of average asset value per year basis. It is unlikely that many individual investors track their ETF trading costs properly and carefully, including 1) brokerage fees, 2) the portion of the bid-ask spread they pay, and 3) the fact that they pay both buying and selling costs on each round-trip transaction.
- While ETFs/ETPs “trade like stocks” they are much more varied that regular equity securities. For example, ETFs also include bond ETFs that “trade like stocks.” While other equity security classes that can trade on the stock markets, the vast majority of equity securities are common stocks. Presumably, individual investors should know what they are buying, when they buy and sell stocks, but this is not always the case. Given the much greater variety of ETFs/ETPs, it is even more likely that some amateur traders make simplifying assumptions about ETFs/ETPs that are not always accurate.
- Since the introduction of ETFs almost two decades ago, ETFs have proliferated and total invested assets exceed $1Trillion. Nevertheless, many investors may not be sufficiently aware that “an ETF is not necessarily an ETF.” Thus, I have included the term, ETP, for the more general class of investment funds that trade on exchanges.
- In addition to ETFs, the class of ETPs also includes:
- closed-end funds (which are diversified mutual funds have been around and traded for decades),
- exchange-traded notes for commodities, currencies, and certificates,
- exchange-traded derivative contracts,
- exchange-traded grantor trusts,
- leveraged ETFs, and other exchange-traded instruments.
- Taxation is one reason why individual, retail traders should understand differences between exchange-traded product investment vehicles. ETFs supposedly are more tax efficient than mutual funds and ETF advocates promote this as an advantage of ETFs over mutual funds.
- Given excessive trading frequency, repeated brokerage charges, and excessively wide bid-ask spreads, it is unlikely that many retail ETF traders actually capture the potential tax advantages of ETFs. Short holding periods also mean that many traders do not capture long-term capital gains tax rate advantages.
- In addition, if an investor does not do his research beforehand and does not understand that “an ETF is not necessarily and ETF”, he may buy another type of ETP with different tax treatment. Lower long-term capital gains tax treatment is not even available with some forms of ETPs. ETPs all have ticker symbols and can be bought and sold easily. For that standpoint, they look the same. The buyer of “an ETP that is not an ETF” may be surprised to find that the tax treatment of some of these ETP vehicles differs substantially from the tax treatment of a plain old common stock ETF. That discovery might not occur until tax filing time. This is another compelling reason actually to read the prospectus BEFORE buying.
- Unexpected performance characteristics of some ETPs are another reason to get educated about various special structure ETPs. For example, certain leveraged long and short strategy ETFs can have surprising performance and volatility characteristics. An uninformed individual investor might not realize the returns that had been expected, even if the market moved a desired direction. For more information, see:
- http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MutualFunds/P119778 and
- http://www.finra.org/Industry/Regulation/Guidance/P119781
