Exchange Traded Funds In A Nutshell
Exchange-traded funds (ETFs) and mutual funds are both viable choices for investors. But, with all their similarities, what differences between the two should investors consider when deciding which to use?
Launched in 1993, ETFs are designed to offer the diversification of a mutual fund and the liquidity and transparency of a stock. Whereas mutual funds can typically be traded only once a day, based on their end-of-day value, ETFs can be bought and sold in real time throughout the trading day. The ETF is similar to a mutual fund in that it is a diversified basket of investments. Like mutual funds, ETFs have a particular investment focus – for instance, ETFs may be made up of only technology stocks, or energy stocks. They may follow indexes: there are some that follow the movement of the Chinese economy and others that track a basket of commodities like corn and wheat. But there are differences:
- While a mutual fund can only be bought at the end of the day value, ETFs are traded on an exchange throughout the day just like a stock.
- ETFs have managers but are not managed as actively as some mutual funds. Most of the underlying stocks stay the same over time which helps keep the fees much lower than most mutual funds.
Mutual funds can typically be broken down into two types:
- Open-Ended Funds
Purchases and sales of fund shares take place directly between investors and the fund company. Federal regulations require a daily valuation process, called marking to market, which subsequently adjusts the fund’s per-share price to reflect changes in portfolio (asset) value. The value of the individual’s shares is not affected by the number of shares outstanding.
- Closed-End Funds
These funds issue only a specific number of shares and do not issue new shares as investor demand grows. Prices are not determined by the net asset value (NAV) of the fund, but are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.
An ETF will have one of three structures:
- Exchange-Traded Open-End Index Mutual Fund
Under the SEC’s Investment Company Act of 1940, dividends are reinvested on the day of receipt and paid to shareholders in cash every quarter. Securities lending is allowed and derivatives may be used in the fund.
- Exchange-Traded Unit Investment Trust (UIT)
Exchange-traded UITs must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less, and set additional weighting limits for diversified and non-diversified funds. UITs do not automatically reinvest dividends, but pay cash dividends quarterly.
- Exchange-Traded Grantor Trust
This bears a strong resemblance to a closed-ended fund but, unlike ETFs and closed-end mutual funds, an investor owns the underlying shares in the companies that the ETF is invested in, including the voting rights. The composition of the fund does not change; dividends are not reinvested but instead are paid directly to shareholders. Investors must trade in 100-share lots. Holding company depository receipts (HOLDRs) are one example of this type of ETF.
ETFs offer greater flexibility than mutual funds when it comes to trading. For mutual funds, the price of the fund is not determined until end of business day, when net asset value (NAV) is determined. With ETFs, however, shares trade throughout the day between investors like a stock. Because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage. (See Arbitrage Squeezes Profit From Market Inefficiency.)
Due to the passive nature of indexed strategies, the internal expenses of most ETFs are considerably lower than those of many mutual funds. Of the more than 900 available ETFs listed on Morningstar in 2010, those with the lowest expense ratios charged about .10%, while those with the highest expenses ran about 1.25%. By comparison, the lowest fund fees range from .01% to more than 10% per year for other funds.Another expense that should be considered is the product acquisition costs, if any. Mutual funds can often be purchased at NAV, or stripped of any loads, but many have commissions and loads associated with them, some of which run as high as 8.5%. ETF purchases are free of broker loads. (See The Lowdown On No-Load Mutual Funds.)
In both cases, additional transaction fees are usually assessed, depending on the size of your account, the size of the purchase and the pricing schedule of the brokerage firm. If you plan to use dollar-cost averaging to buy into the funds or ETFs, frequent trading could significantly increase commissions, offsetting the benefits resulting from lower fees.
ETFs offer tax advantages to investors:
- As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.
- ETFs are more tax efficient than mutual funds because of the way they are created and redeemed. For example, if an investor redeems $50,000 from a mutual fund, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, the fund captures that capital gain, which is distributed to shareholders before year-end. Shareholders must pay taxes for the turnover within the fund. But if an ETF shareholder wishes to redeem $50,000, the ETF doesn’t sell any stock in the portfolio, but offers shareholders “in-kind redemptions”, which limit the possibility of paying capital gains.
Broad-based index ETFs with significant assets and trading volume have liquidity. For narrow ETF categories, or even country-specific products that have relatively small amounts of assets and are thinly traded, ETF liquidity could dry up in severe market conditions, so you may wish to steer clear of ETFs that track thinly traded markets or have very few underlying securities or small market caps in the respective index.ETF Safety Concerns
Investors should not invest in ETFs of a company that is likely to disappear, forcing an unplanned liquidation of the funds that could create a taxable event. Since it is impossible to gauge the financial viability of a startup ETF company, as many are privately held, you should limit your ETF investments to firmly established providers or market dominators.
The “Flash Crash”
The “flash crash” showed that ETFs can be far more complex—and risky—than their mutual-fund cousins. Worse, ETF investors were burned at the very moment they craved safety most. On May 6, when the Dow Jones Industrial Average fell as much as 9.2% during the trading session, many ETFs momentarily lost almost all their value, dropping to pennies per share. Exchanges decided to cancel any trades executed at prices 60% or more away from precrash levels, and ETFs, which account for just one-tenth of all exchange-traded securities, represented about 70% of those with canceled trades. Instead of behaving like broadly diversified baskets of stocks, ETFs performed like single stocks reacting to the actions of panicked traders. The market prices of the ETFs plunged 60% or more.
Making matters worse, many ETF investors had placed “stop-loss orders” designed to protect investors by triggering a sale once the ETF hits a certain level. When ETF prices plunged, however, there were few buyers, and many sold far below the trigger price selected. Then the funds rebounded sharply, adding insult to the injury.
That isn’t to say the flash crash destroyed the rationale for using ETFs. The funds often charge lower fees than traditional mutual funds, and offer easy access to broad slices of the market. And ETFs may allow investors who can’t afford a mutual fund’s minimum initial investment—often $3,000 or more—to buy a similar holding for the cost of a trading commission. Major firms like Vanguard Group and Fidelity Investments have even started offering commission-free trades on some ETFs.
With ETFs, “you can get lower fees and tax efficiency, so long as you tread carefully and trade wisely,” says Paul Justice, ETF strategist at Morningstar.
For those investors still willing to consider exchange-traded funds, here are some new rules to trade by.
Rule 1: Check your wonk tolerance.
The mechanics of ETFs are more complicated than most investors and financial advisers ever realized. If you aren’t willing or able to keep up with the swings in the market or the technical discussion that follows here, it is a good sign that you should stick to ordinary mutual funds.
Rule 2: Try not to trade on a volatile day.
Big institutional players can help ETFs trade smoothly and closely track their benchmarks. But when the markets dive, they won’t necessarily prevent ETFs from plummeting.
So-called market makers—firms that typically help maintain orderly trading in ETFs—need accurate values for underlying fund holdings to arrive at prices where they are willing to buy or sell ETF shares. As stocks swung wildly on May 6, it became tough for these and other institutional players to price ETFs confidently, so many stepped back from the market, potentially exacerbating the rout.
On the all-electronic NYSE Arca, the primary exchange for most ETFs, the lead market makers have certain obligations to keep ETFs trading smoothly, though the exchange doesn’t disclose all of its requirements. These firms made a “reasonable effort” to keep up with the fast-moving market during the flash crash, says Lisa Dallmer, a chief operating officer at NYSE Euronext who oversees exchange-traded products. But given the steep market decline, she says, “it clearly wasn’t enough, because we had trades going off at a penny.”
Many ETF trades on May 6 were executed at “stub quote” prices. These quotes are market makers’ placeholders, often bids to buy shares for just pennies, and never meant to be executed. The phenomenon bewildered even some industry veterans.
Other institutional players, such as high-frequency firms that trade ETFs at blinding speed, also provide liquidity in normal markets. But in a meltdown like May 6, “you can’t mandate that a high-frequency trader stand up on the firing line,” says Gus Sauter, chief investment officer at Vanguard Group.
In the wake of the flash crash, exchanges and regulators proposed “circuit breakers” for individual stocks in the Standard & Poor’s 500-stock index, to help prevent another flash crash. The NYSE’s Ms. Dallmer says the exchange has proposed a list of ETFs that could be a part of this circuit-breaker pilot program, pending the Securities and Exchange Commission’s approval.
Even so, small investors are better off not trading ETFs on the market’s wildest days. And for investors who aren’t comfortable with all of these arcane exchange policies, there is a simpler solution: Stick with ordinary mutual funds.
Rule 3: Use the right kind of trade order.
Even the procedure for buying or selling an ETF can trip up investors.
A “market order” means the trade will be executed at whatever price the market gives you. But as the flash crash showed, those market prices can get unpredictable—quickly.
Investors trading ETFs should use “limit” orders, says Morningstar’s Mr. Justice. That means the trade will be executed only within a specified price range. “You’re not guaranteed execution, but at least [you’re] guaranteed a price,” Mr. Justice says.
Among the strangest results of the flash crash are stop-loss orders turned upside-down.
Dave Hamra, a financial planner who runs Gordian Advisors in Tucson, Ariz., had bought shares in the Vanguard Total Stock Market VTI +2.06% ETF for two clients at about $54 apiece. He placed a stop loss at $50. On the afternoon of May 6, as the ETF’s price bungee-jumped around, Mr. Hamra’s clients got stopped out at an average price of $57.40, or 15% above the stop-loss he had set.
“It was really, really weird,” Mr. Hamra says. Though he has found no explanation for what happened, “I’m much less inclined now to use any stop losses at all,” he says.
Rule 4: Pay attention to trading costs.
Investors tend to think of ETF trading costs only in terms of the commission paid to buy or sell. But the “bid-ask spread,” which is the gap between the price buyers are willing to pay for ETF shares and the price sellers are asking, also can take a sizable bite out of returns.
Though ETFs appear highly liquid, trading billions of shares per day, that liquidity is largely concentrated in a handful of funds. At the end of April, the 10 ETFs with the largest dollar trading volume accounted for more than 60% of total ETF volume, according to the National Stock Exchange.
During the flash crash, typically narrow bid-ask spreads on some ETFs widened considerably. The iShares Russell 3000 Value Index, for example, had an average bid-ask spread of four cents in the first four months of this year; on May 6, its average spread was $2.29, according to NYSE Arca. Investors should generally be wary of ETFs with bid-ask spreads of more than five to 10 cents, analysts say.
Rule 5: Check the underlying value of the fund holdings before trading.
ETF market prices typically hew closely to the value of the fund’s underlying holdings. That is partly because big investors known as “authorized participants” can swap ETF shares for baskets of the underlying securities, arbitraging away any valuation gaps between the two.
But during the flash crash, some ETF prices momentarily bore little resemblance to their underlying holdings. The Vanguard Total Stock Market ETF, for example, seemed to track the market through its sharp decline and the start of its recovery, then collapsed again as its price briefly hit 15 cents, according to a regulatory report.
ETFs also can trade at prices substantially above their net asset value.
To determine if an ETF’s market price is reasonable, investors should check its “indicative” net asset value before they trade. The INAV, calculated every 15 seconds, is an up-to-date snapshot of the value of the fund’s holdings.
The flash crash showed that ETFs require lots of legwork, prompting some investors to wonder if the securities are worth the hassle. Mike Personick, a 33-year-old Salt Lake City small-business owner, is trying to switch from ETF market orders to limit orders in light of the crash. But if it is too much trouble, “I’ll go back to mutual funds,” he says. “I don’t have time to sit around and watch the market all day.”
- Tutorial: Investing In Exchange-Traded Funds