Friday, March 10, 2006

ETF Cons vs. index mutual funds

This is the new question etf, etf investing, etf portfolios


ETF Cons...remember this is all etf cons vs. index mutual funds.

bullet 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 emerging market ETFs). In our opinion, this is the factor which most makes it impractical to utilize 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:

bullet The ETF has a lower expense ratio than the similar conventional index mutual fund.
bullet 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.

bullet 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.

bullet 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 VIPER ETFs. They exist as separate share classes of conventional index mutual funds and are not subject to this adverse effect.

bullet 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).

bullet ETFs have poor coverage of foreign style/size indexes. If you wanted to buy a foreign value ETF, for example, you would not be able to do so at present. There is a much greater selection of non-ETF foreign mutual funds covering the gamut of style and size combinations.

bullet 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.

bullet If the ETF is organized as a Unit Investment Trust (e.g., the SPDR ETFs), 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.

bullet 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).

bullet 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, there are few pros and many cons to using ETFs. However, for certain situations, there are low-cost ETFs which may make sense.


especial thanks to Altruist Financial Advisors LLC

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