"Hubris itself will not let you be an artist" Larry Wall
At the end of 2005, the investment world lost a visionary. Nate Most, the inventor of the Exchange Traded Fund or ETF passed away at age 90 leaving a fundamental change in how investors use the American Stock Exchange. Back in 1993, he introduced the Spider, a fund that traded like a stock but mimicked the Standard & Poors 500 Index of large cap stocks.
This type of tradable index fund shed new light and increased revenues on the beleaguered Amex and as of his passing, accounted for half of the shares changing hands. These funds have now become a force to be considered among the investment community although the $7.2 trillion mutual fund industry still makes light of the threat. Quickly advancing in terms of tax efficiency, lowered fees, and convenience, the ETF has come into its own as a place of indexed protection.
Vanguard and whole host of mutual fund providers have launched their own imitations of ETFs in the years that have followed the introduction of the first ETF. While this is a typical form of Wall Street flattery, many fund managers have found the ETF an excellent place to equitize their cash reserves. So if it good enough for your fund manager, is it good enough for you?
Another benefit of these offerings allows fund managers to actively play industries or sectors that they perceive to be attractive. The risk is not eliminated however and may even be heightened. Many ETFs give the appearance of balance but may in fact be heavily weighted with large holdings creating a disproportionate amount of the index's investment.
If you would like to hear just exactly how an ETF is constructed, I interviewed David Abner on my radio show Financial Impact Factor on November 14th, 2011. If you know nothing about how these funds are constructed, from the point of inception to the actual delivery to the investor, this hour long interview will clear most of your misconceptions about this investment. David Abner on the Financial Impact factor with Paul Petillo)
The Net Asset Value of ETF is calculated in much the same manner as a mutual fund would with certain small exceptions. With an ETF you know that value of the share throughout the day; with a mutual fund, the NAV is calculated at the four o'clock close. The NAV calculated by the mutual fund does not reflect supply and demand; the ETF does. According to tom Lydon writing for ETFTrends: "NAV is the value of each share measured by the value of its underlying holdings and is calculated by using the closing prices of the underlying securities on their respective exchanges." Although using supply and demand as the primary forces in the open market is far better for the investor, it is important to note that the share price of an ETF may be trading higher or lower than the underlying worth.
ETFs outperform mutual funds in terms of flexibility though. The ability to trade throughout the day is one of the primary attractions for investors interested in ETFs. Frequent traders however may feel the sting of commissions more than those who chose another longer term strategy. But ironically, it is the longest term investor that benefits the most from using ETFs.
When I first wrote about ETFs I believed the reason these investments should be avoided was twofold: The first is that pesky problem of discount. In a market correction, ETFs may be on the surface, worth more than the NAV of the securities they represent and the second deals with expenses and the possible illusion that you are saving money. I have always encouraged dollar cost averaging, low expenses, and low entry fees for the mutual funds here at the BlueCollarDollar. ETFs would not fit that criterion - unless of course you could purchase them in your 401(k) - more on that possibility in a moment.
With Dollar Cost Averaging, the act of making regular and steady contributions to a fund to offset high and low markets would rack up an enormous amount of commission costs if you are using an ETF. One lump sum purchase, perhaps with a windfall or a tax return check would be the best wait to fully realize the value of such a trade. This is the very reason Dollar Cost Averaging works so well for most of us.
Expenses are considerably lower than many index funds but this is also a smoke and mirrors effect. Once again, the argument is twofold. Unless you hold onto the ETF for a sufficient amount of time to offset the cost of the purchased ETF (commissions) and one of the most under considered expenses: taxes.
If you invest in an ETF, then you and you alone are buying a share. In a mutual fund, where you buy a share and it acts as a pool of money where the mutual fund manager buys shares to invest for that pool, ETFs are built with the basket in place and you buy a portion of the basket. In a mutual fund for example, when an investor sells their shares, the whole fund feels the ripple effect. In order for that investor to receive the value of their investment, the fund must sell something to pay off the departing shareholder. This can negatively impact the remaining long term investors. If the stocks that are sold have experienced gains, taxes must be paid.
When you sell your shares in an ETF, the remaining shareholders are never impacted either with the potential taxes (selling profitable investments in the portfolio that the fund manager may not have wanted to sell). When you sell your stake in a mutual fund, the remaining shareholders are impacted (which is not really noticeable until large numbers of shareholders make the decision to sell (or buy) at the same time).
With an ETFs, this exchange of invested dollars is done between other shareholders and doesn't impact anyone other than those involved. Be aware though of two things that can be considered taxable and unavoidable. The securities in an ETF may still pay capital gains distributions. The second one is an indexing problem. When the fund needs to rebalance because of a change in the benchmark, stocks sold may have capital gains as well. But I'll admit, these are small concerns.
The choice of ETFs over mutual funds should be considered very carefully. In a long term investment strategy that employs dollar cost averaging, the benefits of ETFs fade very quickly - unless as I mentioned before, they are tucked away inside your 401(k). (once again, you can turn to the radio where I interviewed Neil Plein of InvestnRetire LLC who believes they are not only a good choice in a 401(k), they should be the only choice. Listen to the interview on Financial Impact Factor with Paul Petillo.)
The introduction of actively traded ETFs, however will present new opportunities for small fund companies but at the same time, effect the transparency currently being touted by brokerages will come under fire. Some disagree and there are efforts being made to alleviate this issue. Too much transparency will allow for front running and free riding, problems that do not effect actively traded mutual funds whose portfolios are closed during the trading session and are rebalanced at the end of each day.
The bottom line: ETFs are worth considering. They are worthy components in a retirement plan and lastly, they should be in your company's 401(k) plan. If you do use them though, be cautious of how specific whatever index these funds are tracking. They are formulated by the ETF and may so "drilled down" into a sector as to be lacking the diversity we talk so much about. To use an old WWII adage: "If you got 'em, use 'em."
