Every investor should consider Exchange Traded Funds (ETFs).   The younger brother of open-end index mutual funds is growing up fast and showing greater versatility.

 

ETFs are open-end index mutual funds that trade like stocks (and closed-end mutual funds). 

 

There are three legal structures of ETFs: Open-end mutual fund (the difference between the ETF structure and a open-end mutual fund is the ETF is exchange traded, whereas the traditional mutual fund is purchased and redeemed by the fund itself), Unit investment trust and Grantor trust.   The open-end mutual fund structure has a diversification requirement, mandated by the Investment Company Act of 1940, which limit how it mimics some smaller or specialized indices and could result in a tracking error. The other principal difference for the investor is that other than the open-end mutual fund, dividends must be paid out in cash to investors (of course, you could reinvest them if you desired), rather than reinvested by the ETF. These structural differences aren’t significant for most investors. The more important question is whether it’s the right ETF for you in terms of what index it’s designed to follow. The index and dividend payout requirement are disclosed in its prospectus and most ETFs also have websites where you can find this information.

 

Tracking error is the difference between the return on the index the EFT is designed to follow and the actual return on the index. An EFT which holds all 500 stocks in the S&P 500, in the same weighting as the S&P 500, should have exactly the same return as that index, less fund expenses. That’s an easy one. ETFs that are created to track, say, the biotech stock index will have different interpretations of that index. A biotech ETF could weight all stocks equally, weight by market cap, hold big cap or small cap bio stocks, and so on. As a result, the ETFs performance will vary with the success of its strategy. A good illustration of this is in Biotech ETFs: It Pays to Shop Around, in the October 15^th BusinessWeek. The five funds BusineesWeek highlights had year-to-date return ranging from -3.7% to 27.3%.

 

ETFs are required to disclose their holdings every day, unlike mutual funds which only have to disclose once a quarter. However, this should not be a big deal because we’re dealing with index funds and the components of indexes should not change very often.

 

There are two aspects of ETF liquidity for investors to consider: the ETF and its index’s securities. Since ETFs trade like stocks, they can be traded all day long. Open-end mutual funds can be purchased or redeemed only once daily, after the market closes. You have to put your order in prior to 4PM (while the stock market is still open) or wait until the next day. The liquidity of the EFT – the frequency with which it trades and the depth of the market – is similar to a stock and parallels the size of the EFT. But ETFs also have a very unique feature, they can be expanded or contracted depending upon demand, see Share Creation/Redemption, which provides them with even greater liquidity. And, ETFs can be more liquid than the individual shares they hold, thus, providing investors with greater liquidity. This is especially true for an ETF that holds small cap stocks, which are thinly traded, or bonds other than US Treasuries, which trade infrequently.

 

Authorized Participants, think big banks who act as market makers or specialists on an exchange, trade market baskets of the underlying index’s securities to the EFT in exchange for new ETF shares, when the demand for ETF shares increases. The Authorized Participants then sell these newly created ETF shares on the open market. The process is reversed if there are more sellers than buyers of the ETF.  The purpose of this feature is to keep the ETF’s market price as close to its net asset value as possible. (The risk exists that the Authorized Participants would not, or would not be able to, perform this function during a market crisis. The result of this could be an ETF which trades away from its net asset value.)

The price at which the ETF trades is based upon supply and demand. Unlike the share of an open-end mutual fund which is purchased or redeemed at its net asset value (NAV), the price of an ETF share may trade above or below its NAV. By way of comparison, closed-end mutual funds often trade away from their NAV for extended periods of time. Unfortunately, many closed-end mutual funds trade significantly below their NAVs. The Authorized Participants provide vital role, through share creation and redemption, in keeping the price of the ETF close to its NAV.

The structure of ETFs gives the investor a tax advantage over mutual funds. Open-end mutual funds, even index funds, must sell shares of the stock they own to raise cash when redemptions exceed purchases. These sales can result in taxable gains and losses which are passed along to the investor. Thus, you could have a taxable gain on the fund you own, even though you didn’t sell it. The share creation/redemption process for ETFs shifts this liability to the Authorized Participant. If the Authorized Participant trades ETF shares to the EFT, it is responsible for the taxes on any gains if it sells the securities it received from the ETF. Of course, the investor is liable for any taxes when he or she sells an ETF or mutual fund. 

ETFs have lower fund expenses than index mutual funds, although the difference is usually only a few basis points. (Don’t be misled by ETF advertisements which compare their expenses to actively managed open-end mutual funds.) Theoretically, the expenses for an ETF or mutual fund structured to track the same index, assuming they’re roughly the same size fund, should be the same. 

 

Since ETFs are traded like stocks, the commission charged to buy or sell an ETF is similar to the commission on a stock trade. Index funds are no-load, and are commission free, although some charge a back-end fee if you don’t hold it for a certain period of time. The second cost to consider is the bid/ask spread. Even stock and ETF has one, although in most cases they’re very small, i.e., a few cents, unless the ETF is very illiquid. Transaction costs – none vs. some – favor no-load mutual funds over ETFs but the cost differential is slight

 

What are the uses and advantages of ETFs? Come back next week and I’ll tell you.

Let’s dispel the notion once and for all that index funds are only for passive investors. Sure, the original index funds tracked the S&P and were meant for investors who either believed you couldn’t beat the market or didn’t want to try. Since their beginning, index funds have expanded their breath. You can find a fund which tracks any of the major indices and most industry sectors, such as health care and technology. The first cousin of index funds, Exchange Traded Funds (ETFs), do the same thing – they track indices. Between index funds and ETFs you can mirror any major index, small index, industry sector, industry sub-sector (i.e., biotech or software), global region or individual country. You can also try to outguess the indices if you want. For example, you can buy a S&P index fund which weights all 500 stocks equally or one which weights them by market cap, and so on. (Note to investors: make sure you know what you’re buying.) Thus far, we’ve only focused on equity funds but index and exchange traded funds also are available for fixed income securities. These funds are particularly suited for fixed income investments (Treasury, corporate or muni) because they can buy and sell bonds at much lower spreads than individual investors.

 

The proliferation of index and exchange traded funds means you can construct an entire portfolio of these funds to meet almost any investment strategy and risk level. A combination of a S&P fund, mid-cap and small cap domestic equity funds, foreign funds and fixed income funds of varying maturities, and a real estate fund would fit many investors objectives for a diversified portfolio with good growth potential and reasonable risk.

 

A mix of funds with individual securities or using a fund to fill a gap in your portfolio is an equally good idea. For the investor who wants to participate in, for example, biotech or emerging markets, a fund will enable her to achieve diversification in that sector (and the riskier the investment, the more important diversification becomes) with only a small investment.

 

Index funds can be bought and sold once a day; some ETFs as frequently as every hour. The larger funds are liquid investments and, in many cases, more liquid than their underlying securities (bonds and small cap stocks, for example). Transaction costs are modest, perhaps nothing for a no load fund (subject to certain holding period requirements) and typical stock commissions for an ETF.

 

So what’s the downside? There’s a body of academic literature and models which “prove”’ that a small group of fund mangers can outperform the market, think Peter Lynch and Bill Miller. If you believe this, and I do, or you just want to hedge your bet (I shudder as I write those words because investing is not a bet, it’s hard work and serious business), you can mix some actively managed funds in with your index funds and ETFs. The other issue you have to consider is that index funds/ETFs can take different investment strategies to for the same index. I gave the example above of two S&P 500 funds that are constructed differently. They will perform differently as a result. Structure and performance differences are even more pronounced as you invest in riskier/smaller indices. Taking biotech, for instance, one fund may broadly diversify, another may invest in the ten largest biotech companies, and a third may take a different investment approach. As a result, their performance will widely differ. So, again, make sure you understand your fund’s approach.  You can’t tell a book or a fund by its name.  Index funds and ETFs have a place in your portfolio; they’re no longer just for passive investors.