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Exchange Traded Funds (ETFs) have recently become somewhat popular. At
their heart, they are basically just index mutual funds which are bought and
sold as stocks. In that way, they are similar to closed-end mutual funds
which happen to be index funds. However, they have several interesting
features which make them more similar to conventional (open-end) index mutual
funds.
An obvious question is, "Which should I use, ETFs or conventional index
mutual funds?"
This web page lists pros and cons of ETFs as compared to conventional index
mutual funds. You will note that there are few pros and many cons.
For articles and papers discussing ETFs, see here.
ETF Pros
 | Some ETFs may have lower expense ratios than similar conventional index
mutual funds. If true, this suggests that ongoing management fees would
be lower, which favors ETFs. However, note that most ETFs have expense
ratios which are not dramatically lower than the lowest cost conventional
index mutual funds with similar investment goals.
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| ETFs may be somewhat more tax efficient than similar conventional
index mutual funds. This increased tax-efficiency is in the form of
lower capital gains distributions (which effectively means that an ETF's
capital gains tend to be more deferred than a similar mutual fund's would be). The idea that ETFs
should have lower capital gains distributions comes from their ability to shed
their lowest-basis shares to institutional arbitrageurs through in-kind
redemptions. Note that this benefit applies to a much lesser extent to
Vanguard's ETFs. Because they exist as a separate share class of conventional
mutual funds, any tax benefit a Vanguard ETF generates is shared by investors in
the fund's non-ETF shares, thus diluting the beneficial effect for Vanguard
ETF share
owners.
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| ETFs may have somewhat less "cash drag" than similar conventional mutual
funds. Conventional mutual funds typically need to maintain a small
amount of their portfolio in cash in order to meet ongoing cash redemptions.
An ETF has no such need because it never has to deal with the possibility of
cash redemptions. This may provide a slight advantage for ETFs over
similar index mutual funds. |
Note that if the ETF you are considering has a higher expense ratio than
any similar conventional no-load index mutual fund AND the prospective ETF
investment would not be in a taxable account (e.g., you are in an IRA),
then ETFs will almost certainly underperform the alternative and you should
abandon the idea of using the ETF in favor of the alternative.
ETF Cons
| When you buy or sell an ETF, you implicitly pay (as a "hidden" fee)
one-half of the ETF's "bid-ask spread." Bid-ask spread is the difference
in price between the market price for buying the ETF and the market price for
selling the ETF. Note that, for a conventional no-load mutual fund,
there is no bid-ask spread involved. An ETF's bid-ask spread can be quite
small (e.g., for domestic large-cap stock ETFs and Treasury Bond ETFs) or
quite large (e.g., for certain country-specific emerging market ETFs). In our opinion, this
may be the biggest "con" to consider for ETFs. Bid-ask
spreads make it impractical to hold ETFs for very short lengths of time (i.e.,
because it probably doesn't make sense to incur this implicit
purchase/redemption fee very often).
However, even if an ETF has a large bid-ask spread, it is conceptually
possible for it to outperform a similar conventional index mutual fund in the
long run if (and only if) both of the following are true:
 | The ETF has a lower expense ratio than the similar conventional index
mutual fund. |
| The ETF will be held long enough for the compounded benefit of the lower
expense ratio to exceed the higher costs of the bid-ask spread.
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| In order to buy or sell an ETF, you need to pay a brokerage commission.
If you buy/sell through a discount broker, this might be on order of $10/trade
(no such fees are typically needed to buy/sell a no-load mutual fund).
This fact makes dollar-cost averaging small amounts into ETFs impractical.
ETFs are most practical for deploying relatively large amounts of capital.
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| ETFs may not be as tax efficient as you'd like. At present,
qualifying dividend distributions from stocks are taxed at a preferentially
low tax rate in the United States. One of the requirements to qualify
for this low rate is that the stock has been held for at least 60 days.
Due to share creation activity, this standard may not be met all the time.
Thus, a portion of the dividend income received (and distributed) by the ETF
may not qualify for the preferentially low tax rate for qualifying dividends.
Conventional index mutual funds have more control over this than do ETFs, and
are therefore more likely to have a higher percentage of their distributed
dividends qualify for the preferentially low tax rate.
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| The ETF may have somewhat higher internal transaction costs than a similar
conventional index mutual fund. When the index that the ETF tracks
changes, it must sell all shares of stocks leaving the index and buy enough
shares of stocks entering the index. In order to buy enough of the
replacement stock, it may need to sell shares of hundreds of other stocks —
incurring significant trading expenses.
A conventional index mutual fund
must also sell all shares of stocks leaving the index and buy shares of the
replacement. However, it can do it as part of its ongoing
cash-flow management process. If, for example, the fund has net
purchases (i.e., net cash-flow into the fund), it has to buy some stocks with
that money anyway — and this cash can be used to buy
the new index component. Likewise, if the fund is experiencing net
redemptions, it has to sell stocks anyway — and it
can choose to generate liquidity by selling shares of the stock which left the
index.
Note that this criticism does NOT apply to Vanguard's ETFs. They
exist as separate share classes of conventional index mutual funds and are not
subject to this adverse effect.
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| ETFs won't track indexes as well as conventional index mutual funds.
A mutual fund's share price is always, by definition, the fund's net asset
value (NAV). The NAV is just the weighted-average current market value
of all the fund's holdings, expressed on a per-share basis.
An ETF, on
the other hand, is valued by the market. So even if its holdings are
EXACTLY consistent with those of the index, its market price at any particular
time can be either above or
below the NAV (meaning it can be sold at either a higher or lower price than
the per-share value of its underlying securities).
The difference between NAV and
market price for an ETF won't ever be very high because institutional
arbitrageurs are able to either create or redeem shares of the ETF using the
underlying stocks. This tends to drive the ETF price back towards its
NAV. However, this tracking error is likely to be higher for ETFs which
hold less liquid securities (e.g., emerging markets stocks).
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| ETFs have poor coverage of foreign style/size indexes. If you
wanted to buy a foreign value ETF, for example, there are very few options at present. There is a much greater selection of non-ETF
foreign mutual funds covering the gamut of style and size combinations.
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| There are few bond ETF options available at present. However, note
that ETFs are less desirable for bonds anyway —
since a relatively small portion of a bond's total return is due to capital
gains, the tax efficiency benefit of bond ETFs is relatively trivial.
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| If the ETF is organized as a Unit Investment Trust (e.g., the original SPDR ETF),
then all dividends the fund receives are required to be held in a non-interest
bearing account until distributed to investors. This causes a
"cash-drag" on the fund's earnings which conventional index mutual funds (and
non-UIT ETFs) don't experience.
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| Most people choose to have distributions of conventional mutual funds
automatically reinvested in additional shares of the fund. This is
convenient — it keeps your money working for you
without requiring extra effort on your part to redeploy the distributions.
On the other hand, ETFs don't have this as an alternative. They pay out
distributions as cash. If you want to then reinvest that cash, you need
to take some action to do so (and incur whatever transaction costs apply).
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| Apparently, you can only buy/sell ETFs in whole share lots. In other
words, while you can buy exactly $5,849.23 of some mutual fund, you can't
necessarily buy that much in an ETF — you have to buy whole shares (not
fractional shares). This isn't a big deal, you just have a bit less
flexibility and there may be a little more "cash-drag" in your account if you
use ETFs instead of mutual funds. But then again, ETFs tend to hold
lesser amounts of cash themselves (since they don't have to keep cash on hand
to meet cash redemptions, as do mutual funds). |
Overall, some ETFs may make sense for some situations. However, ETFs
are not the panacea that many advocates claim them to be.
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