What you should know about ETFs

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According to a recent article in the Financial Times, exchange traded funds (ETFs) are taking over the markets[1]. The Financial Times article says that five of the world’s seven most heavily traded equity securities are ETFs. Jack Bogle, founder of asset manager Vanguard, is quoted as saying, “ETFs now account for nearly one-half of all trading in U.S. stocks.” This is extraordinary considering ETFs only started in 1993 and contain a total of more than $3 trillion worth of assets.

ETFs have some important advantages over traditional open-ended mutual funds. They can be a cost-effective way to invest because they normally have lower expense ratios than traditional mutual funds. Investors pay commissions to buy and sell them because they trade on an exchange like a stock. ETFs are generally more tax-efficient, too. The largest tax benefits come from well-diversified index-like ETFs. Most have low turnover and as a result, don’t typically pass capital gains distributions on to shareholders.

Does this mean it’s time to abandon open-ended mutual funds or specifically, actively managed mutual funds? We don’t believe so and we’ll continue to allocate a portion of our clients’ equity holdings to open-ended, actively traded funds.

Worry over index-like equity ETFs and equity management

There are many in the industry who are concerned about the enormous inflows into index-like equity ETFs and worry about the potential for unforeseen consequences. State Street’s SPDR S&P 500 (symbol: SPY) is the biggest ETF with over $200 billion in assets and an average trading volume of 82 million shares[2]. Some analysts believe that over-investment in passive index-like investments (the State Street ETF is just one of many designed to mirror the S&P 500 Index) could cause mispricing because they are market cap size-weighted.

Should the amount of money invested in actively managed funds continue to shrink, passive ETFs would be likely to lose the valuation efficiencies they’ve enjoyed in the past.

A prudent approach to equity management would be to employ the use of both ETFs and actively managed funds. The preferred placement of the more tax-efficient ETFs would be in taxable accounts. The less tax-efficient actively traded funds would be reserved for tax-deferred accounts and Roth IRAs. A customized combination of both active and passive strategies in investment portfolios would have the goal of achieving the best possible risk-based outcome.

Index-like funds and ETF investing

Passive index-like stock returns are less likely to outperform active managers during periods of market declines. This is because most ETFs are designed to mirror an index. To avoid tracking error (deviation from the index), they must always be fully invested. Actively managed funds rarely, if ever, are fully invested. Holding 5-10% in cash allows the manager to take advantage of opportunities as they present themselves. This cash position cushions the value of the fund in declining markets.

Index-like funds lack professional management and therefore the capability for portfolio intervention in challenging markets. Most stock indexes have been reaching all-time highs now that the Dow Jones Industrial Average has closed above 20,000. This is an ideal time to review portfolio allocations to ETFs and other index funds.

Non-traditional ETFs

It is important to point out that not all ETFs are index funds. That was the case for the first ten years of their existence. Non-index benchmarking ETFs were first introduced in 2003. Some of these non-traditional ETFs are designed to follow a specific quantitative investment strategy. Many in the industry consider these actively managed ETFs when choosing their portfolio. Positions in the portfolio are changed when they no longer meet the quantitative criteria.

Another non-traditional ETF is the inverse ETF. The fund is traded like a typical ETF but it is designed to perform as the inverse of the index or benchmark it is designed to track. These ETFs may use short selling, derivatives, or other leveraged techniques to achieve their objective. Using these techniques increases the internal costs of the fund. Consequently, inverse ETFs tend to have higher expense ratios than traditional index ETFS.

Leveraged ETFs are a special type of fund that can benchmark an index or the inverse of an index. The objective is to enhance the movement of the index to double or triple the return of a non-leveraged ETF. The ETF can use swaps, derivatives and re-indexing to achieve their objective but the most common method is by trading futures contracts. The use of these enhancement techniques increases the cost of the fund and the funds volatility.

The vast majority of assets in ETFs are tracking capitalization-weighted market indexes. ETFs that track market benchmarks have significantly more assets in them than ETFs that employ other strategies, which explains why most of the public thinks all ETFs are index funds. Mr. Bogle has been critical of ETFs because he believes they represent short-term speculation and the commissions charged to trade them reduces the return to investors. There is also concern that during periods of market turbulence, the trading price of an ETF may not track its net asset value. Deviations were observed in November 2008 but the average deviation was only slightly more than 1%. By contrast, open-ended mutual funds trade at their net asset value at the end of each trading day.

It’s clear that ETFs and traditional open-ended mutual funds both have advantages and disadvantages. A prudent investment strategy should look for opportunities to add diversification by using both types of funds in their portfolio.

 

Rick’s Tips:

  • ETFs are cost-effective because they normally have lower expense ratios than traditional mutual funds.
  • Less tax-efficient actively traded funds should be reserved for tax-deferred accounts and Roth IRAs.
  • Not all ETFs are index funds. Some employ active investment strategies.

[1] Exchange traded funds: taking over the markets.  Financial Times, December 5, 2016, by John Authers and Chris Newlands

[2] Source: ETF database (etfdb.com)

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