All About ETFs

Is an ETF a form of Mutual Fund?

No, an ETF is an Exchange Traded Fund. While ETFs have some similarities to mutual funds, there are also some significant differences.

Probably the best starting point is to clearly define a mutual fund. A technical definition, provided by www.investorwords.com is "an open-ended fund operated by an investment company which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives. Benefits include diversification and professional money management. Shares are issued and redeemed on demand, based on the fund's net asset value, which is determined at the end of each trading session. A closed-end fund is often incorrectly referred to as a mutual fund, but is actually an investment trust."

Another definition is written by The Motley Fool, which states, "a mutual fund is simply a collection of stocks and/or bonds". Most mutual funds are "actively managed," meaning the mutual fund shareholders, through a yearly fee, pay a mutual fund manager to actively buy and sell stocks or bonds within the fund. Though you would think that mutual funds provide benefits to shareholders by hiring alleged "expert" stock pickers, the sad truth of the matter is that the vast majority of mutual funds underperforms the average return of the stock market's returns. Currently most mutual funds do not make their fees very easy for shareholders to understand." 

ETFs on the other hand are defined by www.investorwords.com as "A fund that tracks an index , but can be traded like a stock." The most well known ETF is the SPDR, which tracks the S&P 500. The Motley Fool writers state, "Probably by now you've heard of these "funds that trade like stocks." They all seem to have these cute names – Spiders, Diamonds, Cubes, WEBS, Vipers, iShares, and so on. But these are mutual funds, right? The Motley Fool can't possibly have anything nice to say about them right? Dead wrong. In fact these products are a dream – for financial service marketers and for Foolish investors alike. Oh, there are some negatives, and we'll discuss those here, but there is much to like about these products, known in aggregate as "exchange traded funds," or ETFs. They have proven so popular that more than 50 new ones have been introduced last year, whereas the first ETF, the Spider, was launched in 1993. I find these investment vehicles to be quite Foolish. They are low-cost, tax efficient, provide ample diversification among groupings of large businesses…"

So, what are the differences between mutual funds and ETFs?

Several. We will focus on costs, tax efficiency, flexibility of trading, and asset management style.

Costs. First, lets talk about fees. Mutual funds generally have three types of charges assessed to the investor. These charges are a one time front end or deferred charge, commonly referred to as a "load", expense charges and 12b-1 fees. All funds have an expense charge, the load and 12b-1 fees are not assessed by every fund. We have seen funds with expense ratios of over 3% per year, 12b-1 fees of 1% per year and loads of 5.75%.

As referenced by the Motley Fool, most investors in mutual funds do not realize the expenses that they pay to invest in the fund.

ETFs also have fees, but they do not have loads or 12b-1 fees. The expense ratios for ETFs are generally 15 to 75 basis points (or .15% - .75%). Generally speaking, the expenses in the ETF are lower than the mutual fund. Please note, however, that normally there is a commission charged on the purchase or sale of an ETF, just like there is on the purchase or sale of a stock. Mutual fund purchases normally charge an upfront sales charge or "load" and as such do not charge a commission. The upfront sales charge is almost always higher than the commissions typically charged on an ETF purchase, however, frequent buying and selling shares of ETFs will result in higher charges. For a buy and hold investor who normally rebalances their portfolio once every 12-18 months, the commissions paid are typically less than the sales charges or loads paid when purchasing mutual funds. For a client holding ETFs in our fee-based account, the commissions are waived in lieu of an annual fee for the portfolio management and advice. In summary, the commissions typically paid on the purchase of mutual funds: the internal fees are almost always considerably less making the overall costs associated with owning ETFs lower than the costs associated with owning mutual funds.

Tax Efficiency. If you are an investor in a mutual fund, 2000 will be a hard year to forget. During this year of stock market decline, most funds lost a significant portion of their value. Then in January, 2001 the mutual funds sent Forms 1099 to their investors detailing the capital gain income (either long-term or as ordinary dividend) on which the investor would be taxed! Tax return preparers heard an uproar from taxpayers who lost significant money in the market, and then had to pay tax on income which they never received. In most cases, the taxpayer didn't even receive any cash flow from the fund.

The sad thing is that mutual fund investors pay tax every year on the gains realized inside the fund, even if they do not receive any cash benefit. Many investors were not aware of this tax structure. The positive returns that many funds had throughout the 1990's overshadowed the tax treatment.

Vanguard, a mutual fund and ETF provider, summarizes the taxation of mutual funds as follows: "A mutual fund is not taxed on the income or profits it earns on its investments as long as it passes those earning along to shareholders. The shareholders, in turn, pay any taxes due. The two types of distributions that mutual funds make are income distributions and capital gains distributions.

 

• Income distributions represent all interest and dividend income earned by securities, whether cash investments, bonds, or stocks, after the fund's operating expenses are subtracted.
• Capital gains distributions represent the profit a fund makes when it sells securities. When a fund makes such a profit, a capital gain is realized. When a fund sells securities at a price lower than it paid, it realizes a capital loss. If total capital gains exceed total capital losses, the fund has net realized capital gains, which are distributed to fund shareholders. Net realized capital losses are not passed through to shareholders but are retained by the fund and may be used to offset future capital gains.

A key component to note is that only net gains are passed through to investors, not net losses.

As stated on the American Stock Exchange website, ETFs tend to offer greater tax benefits because they generate fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency because investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell securities to meet investor cash redemptions, potentially generating capital gains tax liability for remaining investors.

Keep in mind that the sale of either a mutual fund or an ETF will generate capital gains/losses for the investor liquidating shares.

Trading Flexibility. A mutual fund trades only one time a day, generally at the close of the market. ETFs can, and do, trade anytime the market is open. With the volatility we have seen in the market from 2000 through today, this is a tremendous benefit. We are familiar with investors who have entered a buy order on funds at 2:00 p.m. with the Dow down 200 points because they have been waiting for a significant down day to buy. However, by 4:00, the Dow has recovered to positive territory. We have seen investors buying on an up day because they were waiting for signs of recovery, only to have the markets reverse at the end of the session. Another significant example of the difficulty with once daily trading is the aftermath of September 11th, when many investors wanted to get either into or out of the market as soon as it opened. Mutual fund investments by their nature resulted in a delay until the end of the day to trade. While hopefully we will not experience a tragedy on the scale of 9/11, there are other factors, such as Middle East issues, inflation reports, unemployment, political issues, etc. that might warrant an immediate desire to change an investment position.

Asset Management Style. There are several types of mutual fund management styles, primarily including active trading in various sectors or classes and passive management in various sectors or classes. Active management means that the fund managers are researching, and buying and selling individual stocks. In theory, they are buying and selling pursuant to some type of investment or policy statements. For example, a fund may have a policy statement indicating that they are going to be buying and selling aggressive growth technology companies.

Two major concerns with active management are the potential for the manager to style drift, for example the fund with the statement regarding purchasing the stocks of aggressive technology companies may have a manager who is concerned over the volatility in the tech sector, and therefore starts to buy more value-oriented stocks. There is nothing wrong with buying value-oriented stocks, but it should not happen in an aggressive growth fund. A second concern with active management is that often the extra cost paid to purchase the expert advice exceeds any benefit from the active management. Again to quote the Motley Fool site, "although you would think that mutual funds provide benefits to shareholders by hiring alleged "expert" stock pickers, the sad truth of the matter is that the vast majority of mutual funds underperforms the average return of the stock market. Over time, because of their costs, approximately 80% of mutual funds will underperforms the stock market's returns."

ETFs are in the process of putting together some actively managed portfolios, but for the most part the ETFs are index or sector driven, meaning that the stocks purchased are designed to track some indicator. The first ETF, S&P Depositary Receipts, are a good example of how an ETF works. S&P Depositary Receipts, otherwise known as "Spiders," represent a single unit of ownership in the SPDR trust. Units of the trust are bought and sold like individual shares of stock and they trade on the American Stock Exchange under the ticker symbol SPY. As the SPDR trust is a pool of money managed to perfectly mimic the Standard & Poor's 500 Composite Stock Price Index, the price of a unit in the trust is always the current value of the S&P 500 divided by 10. Using passive investing, the investors know what they are buying, that there will not be any style drift, and that their portfolio return will mimic whatever indexes they are tracking.

What else should I know? This sounds too good to be true. What are the drawbacks of ETFs as an investing vehicle? 

One drawback to exchange traded funds is that there is a cost each time a trade is made, in the form of a brokerage commission. If a portfolio was going to have a great deal of trading activity, such as a dividend reinvestment program, dollar cost averaging or a 401(k) monthly contribution, then the costs of trading may offset the expense savings available as compared to mutual funds.

Another concern is that the funds trade on the market, and therefore may not always be trading at the underlying net asset value. Research into the pricing of ETFs has generally concluded that any discrepancy is minor in amount, and usually only lasts for a short period of time. The risk of pricing errors is much higher in funds that do not trade regularly, such as certain foreign ETFs.

What types of ETFs are available? 

There are well in excess of 1000 ETFs available, covering all sectors of the United States market and several foreign markets including broad-based equity indexes (such as total market, large-cap growth, and small-cap value), broad-based international and country-specific equity indexes (such as Europe, EAFE, and Japan), industry sector-specific equity indexes (such as healthcare, energy, and real estate), U.S. bond indexes (such as long-term Treasury bonds and corporate bonds). Please contact one of our representatives for a current listing of ETFs available.

O.K. ETFs sound great, but why don't I just buy individual stocks?

Diversification, diversification, diversification.

Because each ETF is comprised of a basket of securities, it inherently provides diversification across an entire index. Studies have shown that diversification accounts for the vast majority of overall return in a portfolio. Please ask one of our representatives for our white paper on diversification and portfolio return.