Exchange Traded Fund Advantages

ENTRANCE TO WALL STREET SUBWAY STATION

ENTRANCE TO WALL STREET SUBWAY STATION

To make things a bit simpler, we will compare an ETF and a mutual fund that represent the same underlying portfolio (ie: an ETF that tracks the S&P 500 and an index mutual fund that tracks the S&P 500). This way, we can focus on the specific ways in which an ETF and a mutual fund differ.

Intraday Trading
As we mentioned in ETF Basics, a mutual fund will only collect and execute the buy/sell orders for a given day at the end of that trading day (4pm).

Let's say that you owned 100 shares of an index mutual fund that tracked the S&P 500, and the S&P 500 was performing miserably that day. At 1pm, you send your mutual fund manager an order to sell all 100 shares, which - at the time of the order- are worth $20 each. The market continues to fall, and by the closing bell the index mutual fund shares are worth $15 each. Even though you placed your sell order at 1pm (when your shares were $20 each), the mutual fund manager will only executes the order at the end of the trading day at 4pm (at which point your shares are worth $15 each).

Let's work with another example:

Suppose you had $5,000 and, at 11am, it looked like the S&P 500 was going to have a great day. You decide to use you $5,000 to buy index mutual fund shares of a mutual fund that tracks the S&P. At 11am, you send $5,000 to the mutual fund manager.

At the end of the trading day, the fund manager calculates the mutual fund's price per share (also known as the Net Asset Value or NAV). The equation for the NAV is:

NAV = fund assets/ fund shares outstanding 

This fund tracks the S&P 500, and so it holds shares in all 500 companies listed on the S&P. At the end of the trading day, those shares are collectively worth $100,000,000.

NOTE: A mutual fund might also hold other assets in addition to the underlying securities. Our mutual fund may hold cash, so that it can redeem shares if an investor wants to sell them back to the fund manager. Our mutual fund could also hold bonds, so that it can sell the bonds if it needs to generate more cash to redeem shares. However, we will assume that this mutual fund holds no cash or bonds, only its $100,000,000 worth of stocks. Therefore, the fund holds $100,000,000 in assets.

Let's also assume that there are 5,000,000 fund shares outstanding. So, at the end of the trading day, the NAV is:

$100,000,000/ 5,000,000 = $20

So each share is worth $20. How many shares did your $5,000 get you?

$5,000/ $20 = 250 shares

After the closing bell, you get 250 shares of this index mutual fund.

You placed the buy order at 11am though. At that point, the S&P 500 was rising, but not as high as it was at the close of the trading day. At 11am, the collective value of the stocks that the fund held was $80,000,000, not $100,000,000. Had the NAV been determined at 11am, the NAV would have been:

$80,000,000/ 5,000,000 = $16

At $16 per share, your $5,000 could have gotten you more than 250 shares:

$5,000/ $16 = 312.5 shares

You would have received 312.5 shares of this index mutual fund. But instead, you get 250 shares, because the NAV is calculated at the end of the day, not when you place the order. As you can see, this makes it difficult to be certain how many index mutual fund shares you are getting when you place a buy order (demonstrated in the 2nd example) and how much money your mutual fund shares will get you when you place a sell order (demonstrated in the 1st example).

With an ETF, you place buy orders through your broker rather than by sending money to a fund manager. The broker then goes out into the market and finds an investor willing to sell his shares of that ETF, and delivers these shares to you. Just like stocks.

Whereas the the mutual fund's NAV is calculated once per day, the price of ETF shares is being constantly kept in line with the per share value of the underlying securities. Throughout the day, the Authorized Participant is making sure that the ETF is trading at fair value (if it is not, the AP takes the requisite action).

Lower Costs
It costs less to run an ETF than a mutual fund. Remember that- with ETFs- the AP is the one doing a lot of the leg work. Furthermore, the AP does this at no cost to the investor and at little cost to the ETF issuer. This means that ETFs have lower expense ratios than index mutual funds (and much lower expense ratios than actively managed mutual funds).

A fund's expense ratio- also referred to as the operating expense ratio or OER- is the annual rate that the fund charges on its total assets to pay for administration expenses, portfolio management (which is more applicable to actively managed ETFs) and other costs. Be aware, the expense ratio does not include brokerage commissions.

If I want to buy a specific dollar amount of a mutual fund I must send the fund manager a check. For the fund manager, there are operating expenses involved in processing the check and delivering me my shares. On the flip side, If I want to redeem my shares - which I must do through the fund company- the fund manager then has to deliver me my money. This also leads to additional expenses for the fund company.

With an ETF, all trades occur on exchanges. The ETF issuer does not have to process checks or deliver shares or money to individual investors.

NOTE: We are keeping things simple by comparing an ETF and an index mutual fund that track the same underlying portfolio. An ETF still has expenses, and these expenses may rise depending to the asset class (equity, fixed-income, commodities, etc.) that the ETF is tracking. There are instances where an ETF could have a higher expense ratio than a mutual fund, but for an ETF and a mutual fund that track the same underlying portfolio, the ETF will generally have a lower expense ratio.

Flexibility & Access To Anything
So we already know that you can buy or sell ETFs at anytime during the day, whereas you can only buy or sell mutual fund shares after the closing bell. ETFs are more flexible than mutual funds in other ways as well.

For starters- due to the rapid increase in the number of ETFs on the market- it is easy to buy an ETF that tracks a specific asset class and a very narrow market sector, industry or region. There are ETFs for emerging markets, ETFs for gold and precious metals, ETFs or non-US equity markets...the sheer diversity in the ETF market is staggering.

Also, the fact that ETFs trade like stocks means that you can trade an ETF in ways that you cannot trade index mutual fund shares. You can buy ETFs on margin, you can short ETFs and you can place stop/limit orders on ETFs.

HOWEVER (and this is a huge however), when an investor begins trading more "exotic" ETFs or begins trading ETFs on margin, he exposes himself to potentially dangerous amounts of risk. While many broad-based ETFs (such as the SPDR S&P 500) are highly liquid, the same cannot be said of ETFs that target more specific sectors. We discuss the danger in investing in illiquid ETFs in the "ETF Disadvantages" section.

Tax Efficiency
Stock ETFs are, on average, more tax efficient than index mutual funds. Again, this difference stems from the the way an ETF is structured.

The Capital Gains Tax
A capital gain is the profit that is realized when you sell a capital asset (i.e: stocks or bonds) for more than you purchased it for (a capital gain can also occur when you sell a borrowed asset and then buy it back at a lower price, known as a short position). Both mutual funds and exchange-traded funds are required to pay out capital gains to shareholders at the end of each calendar year. The investors who receive these capital gains distributions are responsible for paying the capital gains tax.

There are several ways for a mutual fund to generate a capital gain.

Share Redemption
One way this can happen is if many investors want to redeem their mutual fund shares at the same time. Generally, the fund manager will then have to go and sell some of its stock and bond holdings in order to generate the cash that it needs to pay the investors who are redeeming their shares. If the mutual fund is forced to sell assets that it purchased at a lower price, then the mutual fund realizes a capital gain and must pay these gains out to shareholders.

While the only way a mutual fund shareholder can sell his shares is by redeeming them through the fund company, an investor who wants to sell his ETF shares does so on exchanges. Investors do not redeem ETF shares by going to the ETF issuer.

The AP is the one who redeems shares with the ETF issuer, but remember that- when an AP wants to redeem its shares- the ETF issuer gives the AP a portion of the underlying stocks at fair value (rather than giving the AP cash). Thus, ETF issuer will not realize a capital gains when it redeems ETF shares.

Portfolio Turnover & Repositioning
The stocks within certain indexes, such as the S&P 500, are weighted according to each company's market capitalization (market capitalization = share price * number of shares outstanding). A change in stock price for any of the stocks in the index will change the the index's overall value. But a change in stock price for stocks with heavier weights will have a greater effect on the overall value of an index. These weights will shift over time. 

Thus, in order to accurately track an index, ETFs and mutual funds must occasionally adjust the composition of the underlying portfolio. An ETF issuer or a mutual fund manager may have to sell some of its stock holdings in order to adjust the percentage of each stock that it holds. The sale of these stocks may result in a capital gain.

Even with an ETF and an index mutual fund that track the same stock index, an ETF issuer is able to sidestep a substantial chunk of capital gains when it adjusts its portfolio. Why? Because when an ETF redeems an AP's shares, it gets to choose WHICH shares it will give the AP.

Lets say that our example ETF holds 100 Twitter (TWTR) shares in its underlying portfolio. One day, an AP approaches the ETF issuer to redeem his ETF shares. In return for the ETF shares, the ETF gives the AP a basket of shares of the underlying portfolio, and this basket contains 10 TWTR shares. On that day, TWTR is trading at $50.

Our example ETF was holding 100 TWTR shares originally, but it chose those 10 TWTR shares for a reason. Among the 100 TWTR shares, those 10 were purchased at the lowest price: $30. The other 90 TWTR shares -the TWTR shares that the ETF still holds - were purchased when TWTR was trading between $45-$60.

A few days later, the ETF issuer sells some TWTR shares to adjust its portfolio. Had the ETF issuer sold the TWTR shares that were worth $30 (rather than giving them to the AP), the sale of each of those 10 shares would lead to a capital gain of $20 ($50-$30). Instead, the ETF is able to avoid the capital gain by only keeping the TWTR shares that are trading near, at or above fair value.

Keep in mind, however, that an ETF shareholder will still have to pay a capital gains tax if he sells the ETF shares for more than he purchased them for. The same is true of a index mutual fund shareholder. The key difference is that an ETF shareholder will only have to pay a capital gains tax once (when he sells his shares), while a mutual fund shareholder may end up paying a capital gains tax while he is holding mutual fund shares AND when he sells his shares.

Less capital gains -> Less capital gains tax -> Greater tax efficiency.

Note:  Fixed-income (bond) ETFs or ETFs that track dividend paying-stocks provide no tax efficiency advantage over similar mutual funds. The income generated by bond coupon payments and dividends are passed on to the investor and are taxed as income.

Transparency
Mutual funds only disclose their holdings on a quarterly or semi-annual basis, and these disclosures are on a 30-day lag (meaning information about the most recent 30 days is not provided until the next briefing). An ETF discloses its holdings daily and there is usually a list of holdings available on the ETF issuer's website.

For an investor who purchases shares of different mutual funds in an effort to diversify his portfolio, it is essential that he keep track of each fund's holdings. Otherwise, he runs the risk of investing in multiple funds that hold underlying shares in the same companies (making his portfolio less diverse than he thinks).

This is a very real risk, particularly during asset bubbles. For example, when the tech bubble burst in the early 2000s, investors holding shares of multiple Janus mutual funds were forced to swallow large losses. Although these investors believed that they had diversified their portfolio by holding shares in different Janus ETFs, it turned out that the funds were tracking baskets of stocks containing shares of the same tech companies.

To be fair, those Janus mutual funds were actively managed funds. Index mutual funds are passively managed and -since they are tied to an index- are more transparent than actively managed funds that rely on a fund manager to pick stocks. Still, both active and passive mutual funds only disclose their holdings quarterly or semiannually, and an investor may want to have more frequent access to information regarding a funds holdings.

The transparency of an ETF is a significant plus for an investor looking to diversify. Not only does an ETF disclose its holdings daily, but an ETF will also publish - on a daily basis- the basket of securities that an AP must give the ETF issuer in exchange for new shares, as well as the underlying securities that an AP will get it the AP redeems its ETF shares with the ETF issuer.

Transparency & Actively Managed ETFs
An actively managed ETF - like an actively managed mutual fund- does not track an index. Instead, it tracks a basket of securities that the ETF issuer thinks will outperform the market. Only 5% of all ETFs are actively managed; the rest are passively managed ETFs that replicate, not outperform, an index (conversely, more than 75% of all mutual funds are actively managed funds and 12% are index mutual funds)

One reason why actively managed  ETFs make up such a tiny percentage of the ETF market is because all actively managed ETFs are required by law to disclose their holdings on a daily basis. As you might expect, an ETF issuer who creates an ETF that is meant to outperform the market may not want to reveal which securities his ETF tracks. 

To solve this issue, fund mangers and stock exchange operators have recently been pushing the SEC to allow "non-transparent" ETFs to list on exchanges. A non-transparent ETF is an actively managed ETF that discloses its holdings quarterly. Keep an eye out for developments here.