In and Outs of ETFs

Mark Salzinger Editor and Publisher, The No-Load Fund Investor

The investment world has changed greatly since the heyday of actively managed no-load mutual funds, which coincided with the Internet boom and established various portfolio managers as near-celebrities.

As that era slips further into the past, investors increasingly realize the importance of cost and the related difficulty of consistently outperforming the markets. As a result, index funds have exploded in popularity, and low-expense index exchange traded funds (ETFs) have been in the forefront of this trend.

Here's some insight into these investment vehicles and how I use them in the context of a broad portfolio that also includes conventional mutual funds.

Blackrock (iShares), State Street (SPDRs), Vanguard, Guggenheim, WisdomTree and PowerShares are the largest providers of ETFs.

These and a few other smaller providers offered a total of 1,646 different ETFs, ranging from those based on broad, mainstream indexes like the Wilshire 5000 and S&P 500 to narrow, industry-sector ETFs, and even many ETFs for individual foreign countries and commodities.

Structurally, ETFs resemble regular index mutual funds internally, but trade on exchanges like stocks. Instead of buying and selling shares of ETFs through mutual fund companies, you buy and sell them through brokerage accounts, basically like you can a stock.

That means instead of putting in your order and getting the price as of the end of the trading day, you get the prevailing market price during the day (a market order) unless you put in types of orders that are executed only at a certain price (a limit order).

This allows investors to take advantage potentially of temporary market dislocations intraday to buy at low prices, or to sell positions at high levels they believe will not be sustained at the end of the day. It also eliminates any concerns about fees for early redemption, which do not exist for ETFs but do for many conventional mutual funds.

While most regular index mutual funds came about after the founding of their respective benchmark indexes, many ETFs are based on indexes that were specially created to be ETF-shareholder friendly, with low turnover being a prime consideration.

Though an increasing number of ETFs are based on indexes formed by quantitative methods developed to beat older, mainstream indexes, these ETFs are still index products. Once the methodology of the ETF is established, limits on rebalancing tend to limit the turnover and enhance the tax efficiency.

In fact, tax efficiency and tax independence are two of the most attractive features of ETFs, at least for your taxable accounts. They’re the single biggest factors separating them from old fashioned mutual funds.

With a conventional fund, the tax bills depend not only on your own buying and selling, but on that of every other shareholder within the fund as well as on the portfolio turnover and practices of the manager.

If substantial redemptions of a fund necessitate that its manager sells holdings at substantial profits, the tax burden is shared among all the fund’s shareholders, not just on those redeeming.

Though the particulars are somewhat complicated, the process by which shares of ETFs are created and redeemed generally results in fewer taxes owed on the part of remaining shareholders, especially as compared to most actively managed mutual funds.

After superior liquidity and excellent tax efficiency, the main advantage for ETFs is low expense ratios. ETFs have low expense ratios because the products don’t cover the costs of distribution or of shareholder accounting, record keeping and account servicing (instead, the brokerages cover these costs), and because providing index funds is a highly competitive undertaking for which premium prices cannot be charged.

Because fund accounting and administration are done at the brokerage level as opposed to the fund level, ETFs should have lower expense ratios than all actively managed funds and most no-load index funds.

Brokerages are compensated for these costs partly by charging commissions on purchases and sales of ETFs, as they do with stocks. These commissions, plus a bid/ask spread [narrow for broad ETFs, wider for more narrow, less frequently traded ones], represent the cost to retail investors for buying and selling shares of ETFs.

Therefore, the cost comparisons among various ETFs and similar index funds come down mainly to the benefit of the ETF’s slightly lower expense ratio against the no-load feature of the regular index fund.

The amount, frequency and turnover of your investing impact the cost comparison greatly. ETFs may be attractive options especially if you want to make one large investment and hold it for many years. That’s because you pay the commission only once (usually a flat rate no matter the size of your purchase), while benefiting from the lower expense ratio over your entire holding period.

On the other hand, if you want to invest smaller amounts regularly, regular no-loads may be preferable, since commissions on multiple purchases of ETFs will eat into your returns.
In many cases, ETFs are the only options for investors who want index-fund exposure to certain countries, industries and commodities. For example, if you wanted to make a concentrated bet on a certain Pacific Rim county, such as Taiwan, you’d be able to do so only through an ETF.

The same goes for a pure index bet on pharmaceuticals, or many other industries. ETFs even provide you with several options to invest in actual gold bullion, without the cost and inconvenience of actually storing and protecting the metal yourself, plus ones for silver, platinum and palladium.

Where ETFs and actively managed funds emphasize the same type of investment, it would make sense to consider the latter group only if you believe it’s going to beat its index.
If instead you are seeking generic exposure to a certain size or style segment of the market, you might as well go with an ETF or a conventional index fund, and skip the unpredictability and higher expenses of the actively managed product.

In my own investing, I combine traditional open-end index and actively managed funds with new investments in specific ETFs. Because I continue to believe in the possibility of picking actively managed funds that can beat their benchmarks, I still invest a greater percentage of my money in actively managed funds than in index products, ETF or not.

In fact, my own ETF exposure is like a barbell. On the one hand, I sometimes use ETFs for very broad market exposure. On the other, I also use them to obtain exposure to niche areas of the market that are more difficult to target with actively managed products.

Often, they’re simply the only alternative for that kind of investment. Between those two extremes, I tend toward actively managed funds led by people and/or guided by processes that I believe are more likely than not to beat their benchmarks over the long run.

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