Exchange-Traded Funds: what you should know
Exchange-Traded Funds: what you should know
Christopher Traulsen, Senior Analyst, Morningstar Inc.
Unless you've been living in a cave for the past year, you've probably heard the buzz about exchange-traded funds (ETFs). They've been around for years, but as giant asset managers such as Barclays Global Investors and Merrill Lynch have rolled out scores of new offerings in recent months, and Vanguard readies its own version, called VIPERs, they've become the hot topic du jour.
This article provides an overview of the world of ETFs, including how they differ from regular mutual funds, what their advantages and disadvantages are, and how to ascertain whether or not they might be appropriate for you
What are Exchange-Traded Funds?
At the most basic level, ETFs are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange (all available offerings currently trade on the American Stock Exchange). Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin---in brief, anything you might do with a stock, you can do with an ETF.
Most also charge lower annual expenses than even the least costly index mutual funds. However, as with stocks, you must pay a commission to buy and sell ETF shares, which can be a significant drawback for those who trade frequently or invest regular sums of money.
There are a number of different ETFs on the market currently, including Qubes, SPDRs, sector SPDRs, MidCap SPDRs, HOLDRs, iShares, and Diamonds. All of them are passively managed, tracking a wide variety of sector-specific, country-specific, and broad-market indexes.
Their passive nature is a necessity: As we'll explain later, the funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. Active managers, however, are loath to disclose such information more frequently than the SEC requires (which currently is twice a year).
How do ETFs work?
Although ETFs are more flexible than mutual funds in many respects, and they can be traded on an exchange throughout the day, their shares cannot be bought from or sold back to the fund company like regular mutual funds. With the exception of Merrill Lynch's HOLDRs, investors can only buy or redeem shares directly from the fund company in 50,000-share blocks, and even then, the funds require in-kind transactions---that is, you don't get cash when you redeem your shares, you get the underlying stocks. In practice, this means that only institutions and the very wealthy can afford to deal directly with the fund companies. The rest of us have to go through a broker to buy and sell shares.
Unlike regular mutual funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, the market price of an ETF is determined by forces of supply and demand for the ETF shares. To a large extent, the supply and demand for ETF shares is driven by the underlying values of their portfolios, but other factors can and do affect their market prices. As a result, the potential exists for ETFs to trade at prices above or below the value of their underlying portfolios.
However, by permitting large investors to buy or redeem shares in-kind, the fund companies behind ETFs have created a mechanism that should, in theory, help prevent sustained discounts or premiums from opening up.
If an ETF traded at a discount to its net asset value, institutional investors could assemble 50,000-share blocks in the open market at the discounted price, redeem them for the underlying stocks, and sell those stocks at a profit. The actual transaction isn't quite that simple, but the idea is the same: The arbitrage opportunity would generate sufficient demand for the discounted ETF shares to close the gap between their market price and the net asset value of the underlying portfolio.
Are ETFs right for you?
ETFs have several clear advantages over traditional mutual funds. Most notably, their annual expense ratios are considerably lower. They're also more tax-efficient, and they can be traded throughout the day. Nevertheless, they aren't suitable for everyone.
Trading flexibility
One key advantage that ETFs have over traditional mutual funds is trading flexibility. ETFs trade throughout the day, so you can buy and sell them when you want. However, the arbitrage mechanism that keeps the prices they trade at in line with their NAVs isn't fail-safe. Heavily traded issues such as SPDRs (which track the S&P 500) and QQQs (which track the Nasdaq 100) should trade right around the value of their underlying securities, but premiums and discounts could arise, especially for thinly traded funds. Moreover, it is not yet known how ETFs might behave in the face of a full-fledged market correction. It's conceivable that investors wishing to sell in the midst of such an event would have to part with their shares at prices below their net asset values.
Costs
In terms of the annual expenses charged to investors, ETFs are considerably less expensive than the vast majority of mutual funds. SPDRs, for example, recently reduced their annual expense ratio to just 0.12%. IShares' annual expense ratios range from 0.09% for iShares S&P 500 Index, to 0.99% for several of its iShares MSCI Series offerings (formerly known as WEBS). Still, investors need to put these numbers in perspective. On a $10,000 investment, you'd save just $9 a year by choosing iShares S&P 500 Index fund over Vanguard 500 Index Fund VFINX. (The latter charges just 0.18% per year for its services, but on small accounts Vanguard also levies an annual fee of $10, which increases the iShares' edge).
The expense advantage of ETFs may also prove to be more mirage than fact for most investors. That's because you must pay commissions to buy and sell ETFs, just as you would for stock transactions. If you plan on making a single, lump-sum investment, then it may pay to choose an ETF. However, even assuming a low commission of $8 per trade, a single lump-sum investment of $10,000 in the iShares S&P 500 Index would need to be held for nearly two years to beat Vanguard 500 Index's costs.
ETFs' low expenses are touted as one of their key benefits, but the fact remains that if, like most of us, you invest regular sums of money, you'll actually end up costing yourself far more with an ETF than you would with many mutual funds. Also, for the same reason, investors who wish to trade frequently would be much better off from a cost perspective with a regular mutual fund than with an ETF. (Most mutual funds discourage active trading, as it hurts the returns of long-term investors, but some, such as those in the Rydex family, encourage the practice).
Taxes
With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital-gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions. Furthermore, redemptions made by large investors are paid in kind, again protecting shareholders from taxable events. All of this should make ETFs more tax-efficient than most mutual funds, and they may therefore hold a special attraction for investors in taxable accounts. Keep in mind, however, that ETFs can and do make capital-gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying benchmarks.
Performance
Because they are shielded from investor trading, ETFs shouldn't suffer from having to keep cash on hand to meet redemptions, or from being forced to sell stocks into a declining market for the same purpose.
That said, not all index funds are created equal. Barclays' iShares haven't been around long enough to draw meaningful comparisons with index mutual funds, but Vanguard 500 Index has soundly beaten Barclays' S&P 500 index mutual-fund offering over the years. The iShares S&P 500 offering could fare better--after all, it won't have to cope with cash inflows and outflows. Nevertheless, it tries to exactly replicate the index, while the Vanguard offering uses futures to boost its returns. If it persists, Vanguard's superior performance could easily outstrip the iShares' expense advantage over time.
How HOLDRs differ from other ETFs
Unlike other ETFs, investors in Merrill Lynch's HOLDRs can exchange their HOLDRs for the underlying stocks at any time by paying a charge of up to USD10. That feature should keep HOLDRs' prices in line with the value of their holdings. If a HOLDR trades at a discount to the net asset value of its underlying portfolio, investors could buy the HOLDR, exchange it for the underlying stock, and sell the stock at a profit.
HOLDRs have their limitations, however. Whereas individual investors can trade ETFs over an exchange in lots of any size, HOLDRs can only be bought and sold in 100-share lots. That puts many of them well out of the reach of individuals. Currently available HOLDRs also focus on narrow sectors such as biotechnology, semiconductors, and broadband. Thus, even if you can afford them, they should probably play a limited role in your portfolio. Finally, HOLDRs never add stocks to their portfolios, and will drop holdings whose stocks are merged out of existence. As a result, their portfolios, which only hold 20 stocks to start with, can become concentrated in fewer names over time. HOLDRs are also not registered investment companies, and thus aren't subject to the same diversifcation requirements as other ETFs. In particular, as registered investment companies, other ETFs are not permitted to have more than 25% of their assets in any one issue at the end of a quarter, but HOLDRs are not subject to this restriction.
Conclusion
ETFs have a lot to offer. They're flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading, making them more tax-efficient than most mutual funds. There are also ETFs that address specific subsectors that regular mutual funds do not.
Nevertheless, look carefully before you leap. ETFs' cost advantage isn't always as large as it might seem, and trading costs can quickly add up. Particularly if you're in the market for a fund that tracks a broad index such as the S&P 500, or if you wish to invest regular sums of money, it's tough to make a case yet for choosing an ETF over one of the existing low-cost mutual-fund options.
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