To keep this post reasonably short yet useful, I’m not going to spend time on defining or explaining the exchange traded fund (ETF). If you want to learn more, a great place to start is ETF University at etf.com, or read The ETF Book, by Rick Ferri.
And for those who want the executive summary, here it is. ETFs are better than mutual funds and should be the main tool for portfolio construction. Criticisms of ETFs, even by the great John Bogle, are easily dismissed, and many criticisms are based on pure ignorance. So, if you’re not using ETFs in a major way, you’re doing yourself a disservice.
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ETFs seem to be getting a bit of bad press these days. First is the question of ETFs vs. mutual funds and which is better for building a portfolio. Then there are those who say that ETFs are an accident waiting to happen, or that they are going to be the undoing of the capital markets altogether. I want to use this post to clear the air a little bit while giving folks some free advice. Let me start by throwing this grenade: ETFs are in no way inferior to mutual funds and in many ways superior to them. In fact, ETFs may be the best piece of financial engineering since the first mutual fund was created back in 1924. For modern finance related posts, you can read this one about the pitfalls of equity release.
Relative to mutual funds, ETFs are cheaper, more tax-efficient, more easily traded, and more transparent. There are a few reasons one might want a mutual fund over an ETF (some asset classes, such as bonds, are better suited for mutual funds, a point I’ll leave for another day), but for the most part, ETFs should be an investor’s tool of choice for portfolio construction.
Cheaper. The average ETF fee is about a third of the average mutual fund fee. Much of that price difference is because ETFs are primarily passive vehicles while mutual funds cover both the active and passive investing worlds (I will tackle the active-passive debate in my next post). If comparing an ETF with its comparable mutual fund then the fees are quite similar, but ETFs are most definitely not more expensive so overall they get the nod on the all-important price issue.
More tax-efficient. Because of their unique structure (again, for a full explanation see the previously mentioned sources) ETFs are able to pass any internally-generated capital gains on to others, leaving investors fully in control of their own capital gains when they sell. Mutual funds, on the other hand, are structured so that capital gains created from redemption activity by fund sellers must be passed on to current holders, creating capital gains and losses for which they were not responsible. In the worst years, mutual fund holders pay taxes on capital gains without ever selling and when the price of their fund has dropped significantly!
More easily traded. ETFs trade like stocks, so you can buy or sell throughout the day and you always know the price you are getting. Mutual funds, on the other hand, are only bought/sold at the end of the day at the end-of-day net asset value, which is impossible to know when you place your trade order. For mutual funds, it’s entirely possible that you buy or sell at a price very different from what you expected if the market moves significantly from when you placed your order. Added to that, the mutual fund industry has been caught playing games around end-of-day pricing that significantly favored a few at the expense of the many (for more information, click here). You can’t play those games with ETFs.
More transparent. ETFs are required to publish their holdings daily. Mutual funds, on the other hand, are not, and in most cases you will not know exactly what is in a mutual fund on a given day for at least a month. So, when you buy your mutual fund you can only know what was in it thirty days ago rather than when you buy it, and you will only find out what was in it when you bought it thirty days later. Rule number one in investing is to know what you’re buying, which is in some sense impossible with mutual funds. Now try constructing a portfolio of several funds when you really don’t know what’s in any of them! With ETFs you have no doubt what’s in it or whether its holdings conflict with others in your portfolio.
Yet there are critics of ETFs. Perhaps the most famous is Jack Bogle, founder of Vanguard and champion of small investors everywhere. While I agree with Jack on most everything, I do part ways with him on this issue although I understand his point. His criticism is that ETFs are open to misuse because of the ease with which they can be traded. While I don’t dispute that point, I contend that it is an easily overcome issue…don’t trade your ETFs. Just because they offer that flexibility, it doesn’t mean you have to use it. Consider antibiotics – overuse is a dangerous thing but we most definitely want them around!
The rest of the criticisms of ETFs seem focused on one of two things: pricing efficiency concerns arising from the massive flows from mutual funds into ETFs (driven by a collapse in confidence of active investing which again, I’ll address next time), or of trading glitches we’ve encountered a couple of times already in 2010 and 2015. While these concerns are worth considering, in the end they are much ado about nothing.
The pricing efficiency critique is an interesting one. The argument is that the ton of money flowing into these passive vehicles creates a false demand on all the underlying securities and pushes their prices up to speculative levels. Simply put, a bunch of buy orders will drive prices up, creating a bubble that will eventually pop. This is a variation of the concern that as the popularity of active investing wanes, there won’t be an adequate amount of price discovery in the markets and we will no longer know what the real price of anything is since nothing trades on their fundamentals anymore. While all of this is fun to ponder, the bottom line is that there remains a more than adequate amount of price discovery out there and while things are shifting from active to passive, there are still plenty of active investors waiting to capitalize on any pricing discrepancies they find. The number of trading strategies have never been higher, and so the tug of war for the price of any individual security is very robust. Prices are as accurate as all the various opinions can make them, so those who worry about a “bubble” from the recent popularity of ETFs to me just shows their ignorance of how markets, and specifically, ETFs work.
With respect to the trading glitches the ETF system has encountered over the years, the only thing to say is that we are imperfect beings striving to be more perfect, working in imperfect markets that we are trying to make more perfect. Stuff happens, and while I am quite confident glitches will continue to happen in the coming years as we uncover new ways markets can screw up, those who are smart and responsible actors who don’t overreact or get greedy in those rare moments when things go momentarily haywire have little to worry about. In each “flash crash”, things corrected very quickly and the only folks who got hurt were the irresponsible or ignorant traders trying to take advantage of the situation. The rest of us moved right through it as though nothing had happened and the industry then examined the situation and made improvements where necessary. Beware the Chicken Littles screaming of a falling sky.
So, I encourage all investors to make ETFs their primary tool in portfolio construction. They allow you to build extremely robust investment portfolios for almost nothing, with great liquidity, transparency, and tax-efficiency. But one needs to do proper research, since only a small fraction of the over 2000 ETFs are worth investing in. The vast majority are a combination of gimmicky algorithms, perhaps leveraged and risky or narrowly focused, or simply pointed at an inferior index. It’s important to be very thoughtful if you want the best results, and above all else…be an investor rather than a trader.