Exchange Traded Funds, Index Funds, Actively Managed Funds

Critical Stuff: ETFs are an easy way to buy exactly the kind of index you want, anytime you want.

In This Chapter: The 20 Trillion dollar business. Arbitrage to Market Value. Expense Ratios and other bullshit.

A fine opportunity for fraud: Hollow ETFs

 

Index Fund vs. Exchange Traded Funds vs. Actively Managed Mutual Fund

This is confusing stuff, so read carefully. We’re talking about three different kinds of funds that look similar in many ways and even sound similar in their naming. To differentiate which we are talking about we’ll use the initials ETF for Exchange Traded Funds, IF for passively traded Index Mutual Funds, and AMF for Actively traded mutual fund.

An Index Fund (IF) is a special version of Mutual Fund which invests in the stocks that comprise a specified index. Since the composition of the Index Fund is fixed, there isn’t much for a manager to do, so the fees are low. A stock market index is simply a list of stocks related in some manner. In investment terms, it means a fund that holds all the stocks that form a specific market with the percentage of each stock held being determined by some formula based on a ranking value. You could form an index of the 50 largest companies in the US, and then decide on how the value of those companies should be represented in the ordering and overall value reported for the index. You could base the value on market capitalization, or revenue, some balance sheet number, or any arbitrary measure. For example, the Standard & Poor 500 index represents the value of 500 major company stocks in various market sectors in a basket of stocks weighted by market capitalization. Indexes can be based on any characteristic, such as market sectors, market size, asset type, commodities and real estate and can be weighted by any factor.

When you buy an Index Fund (IF) you actually own shares that comprise the index. An ETF is also an index of shares, but they are created and held differently, and when you own an ETF you don’t actually own the shares that comprise the index. The fundamental difference between an ETF and an Index mutual fund (IF) is in how they are traded and priced. ETFs are considered more flexible and more convenient than IFs and they can be purchased whenever the market is open and in smaller increments–generally whatever a single ETF share costs. ETF shares are priced in the market, exactly like stocks whereas IFs are priced only after market closings based on the current value of the stocks in the fund. ETFs are priced and traded continuously throughout the trading day exactly like common stock. Their value is also based on the underlying set of defined assets but the price is more market driven. Theoretically, the arbitrage opportunities that arise whenever the price for the ETF deviates from the price of the assets that make it up tend to keep the price of any ETF tightly in line with the securities that form it. For example, if an ETF price is lower than the basket of stocks the ETF represents, an authorized trader (not you) can buy the ETF at that discounted price and then sell the component stocks for a higher price. If the ETF is trading at a price higher than the stocks it is made up of, the traders would sell it off, driving the price down. Don’t misunderstand this kind of trading. The normal run of ETF shareholders own shares in the fund, they don’t have a direct claim on the shares that comprise the fund.

Shares making up an IFs are generally bought and sold only through the company that manages the fund, with the shares the fund holds in the hands of a custodian. When a shareholder of the fund wants to redeem their IF shares, the manager sells the appropriate number of component shares and pays the owner the proceeds. When a shareholder buys shares the manager buys the appropriate stocks to match the index structure. This means the basis for capital gains taxes in the fund is complex and a portion of all the capital gains from any sale of assets in the fund is passed through to fundholders.  While this appears to be a major flaw, for most IFs it’s not much of an issue. The funds tend to be “buy and hold”, and the massive size of the more popular IFs makes trading a fractional issue.

Most ETFs use a similar custodial structure but the supply of ETF shares are regulated through a creation/redemption process, where authorized parties create shares by assembling the portfolio of assets and exchanging these with the fund for ETF shares. For redemptions, these traders provide ETF shares to the fund and receive assets consisting of the underlying portfolio. These are also generally the traders that can arbitrage improperly priced ETFs.

Unlike an AMF mutual fund that has an active manager who generally divulges their investment intent for the fund but is expected to trade more or less freely in an attempt to increase performance over the market, an ETF generally follows a rigid design. For example, they might replicate an index benchmark closely. This ensures diversification and removes the emotion and risk of market timing decisions. As the ETF expands with more people buying it, the concentrations of investments stays the same, replicating the benchmark with simply more shares of each asset, whereas an actively managed fund often strays from the original intent when the number of investors increases.

The fixed design makes the ETF simple to manage which should result in much lower expense ratios. Expense ratio is a mumblemouth way of saying the fee the administrator collects as a percentage of the fund. ETFs have another pricing advantage–since they are bought and sold during normal exchange hours just like any stock, and the volumes of transaction of the most popular ETFs are huge, they are fairly liquid. For that reason, most have very low costs to transact and the transaction times are very short (the span between offer and bid is short). Some companies like Vanguard charge no transaction fee for ETFs and execute trades almost instantaneously. Most mutual funds, including IFs charge a substantial fee for transactions and trade once a day,  which can make for a substantial difference in the asked and offered price.

The benchmarks generally change infrequently and slowly, so passive index-tracking ETFs have a low turnover rate. This can be a big tax advantage over AMF mutual funds that are being traded to suit the managers fancy without regard to your tax situation.

ETFs provide the same fees and terms to all investor. And whether you are buying ETFs yourself, buying through a fee-only advisor or using a Robo you are not paying for all the sales commissions and fees that fee-based advisors collect, and you are not exposed to the sales pressure that the conflict of interest with fee-based advisors inevitably engenders. AMF Mutual funds can be sold directly to you by companies like Vanguard, but most AMF sales come through some kind of sales channel. Each layer of the channel adds fees, and they can be hard to ferret out–all you know is that the “performance” is a little disappointing. That’s because you’re dragging all those fees along. You can be paying fees as front and/or back loaded costs or back-channel commissions to your advisor, as well as paying the advisor.

If you’ve traded mutual funds directly you’ve probably experienced some capital gains that get distributed to you at year-end even when you haven’t sold anything. That’s because when a shareholder of a mutual fund liquidates their holding the fund’s administrator sells securities to get cash needed for the redemption–the cost basis for AMF funds is so complex that the accepted solution is to distribute capital gains among all investors. Additionally, in AMFs the churn of stock positions held can be very high, and each position sold can create some short-term capital gains if the holding period is less than a year. These sales generate capital gains that are distributed to all shareholders in the fund. If you are holding mutual funds for the long-term you are paying capital gains for the shorter term investors. If a shareholder in an ETF liquidates they sell their shares to another investor and generate a capital gain or loss only for the seller. The capital gains in the creation/redemption process do not pass through to the shareholders.

ETF’s also have a very low expense ratio, about 10-15 points (.10 to .15%) for bond ETFs and 15-30 points for stock ETFs. That varies depending on the fund and who is selling it. By comparison, conventional IFs cost a few more points, typically 15-25 points for bond funds and 18-35 points for stock funds. That’s really not much of a difference given that AMF expense ratios are more than 1 percent (100 points) on average.

With all these benefits its no surprise that ETFs have grown rapidly over the last decade. But so have IFs, which share many of the same benefits. It’s really the actively traded AMF mutual funds that are getting clobbered by the growth of these investment types–as they should be. With any investment, you need to look at the structure, asset classes, expense ratio, and overall cost of ownership of any ETF or Index Mutual Fund. With some of the more exotic ETFs there are also trading costs, deviations from the benchmark, and basic management issues like errors in tracking to pay attention to. With many companies entering the field and all of them trying to differentiate themselves (big ETFs are more attractive than small ones, so no little upstart ETF that looks just like an established, big ETF is going to get very far), the slate of ETFs is getting more difficult to navigate. It’s reasonable to focus on the largest and most established companies, or to consider a robo investor system for acquiring and holding ETFs. Leave the exotica for the financial hobbyists and experts.

If you don’t choose to heed that advice, be careful. ETFs have become a speculation tool for some people. And ETFs can be surprisingly hollow without anyone going to jail. The assets that back them are pledged–they don’t sit in a vault. The entities that pledge the shares that back an ETF may choose not to exchange the shares for ETFs when a lot of people are trying to exit. They can and have become illiquid, which generally forces them to close,  and when ETFs close it can be a long time before you get a settlement of the funds due to you. There is also a lot of securities lending going on under the covers of almost all ETFs, a lot of the profit of ETFs probably comes from this. I say probably because information about it is hard to come by. If the company managing the ETF decides to keep the fees from lending securities, the loan represents an uncompensated risk for the shareholders. The practices of the ETF companies for sharing lending fees vary greatly. Vanguard gives investors 100% of the profits from lending. At the other end of the scale iShares won’t discuss and does not disclose how it handles lending fees. If they won’t disclose, then it’s a safe assumption that they keep them.  For all these kind of reasons, it’s not rare to see an ETF trading at some discount from the value of the assets that comprise it, even though the underlying theory of ETFs is that arbitrage would eliminate that gap. No one can arbitrage an ETF with a pledge entity that isn’t exchanging shares.

There’s an online magazine called ETF report (ETF.com) that covers ETFs in detail. Reading it will probably scare the crap out of you, but the focus of publications like this is exotica and interesting stories. A solid ETF humming along on track is not interesting. For most investors, ETFs represent a simple and effective way to invest in a broad swath of a market segment. The potential volatility and risk of ETFs is real but rare. There’s more than 20 trillion dollars invested in ETFs. As Mom used to say, “just because Johnny does it doesn’t make it OK for you.” But 20 trillion? Jeez.

All the same, I tend to focus more on Vanguard index based funds and DFA funds. Since they consist of the actual shares of the stocks the index the fund represents, they never trade at a discount to the net asset value, and therefore there’s no speculative aspect–they can’t effectively be shorted. The “slowness” of their trading makes them unpopular for speculation–they are priced, bought and sold at market close, which of course is the only time the shares that make them up can be priced.

There’s very little excitement with Index funds, which is fine with me. I get my excitement surfing, stand up paddling and mountain biking, not in retirement investment.

 

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The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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