Wednesday, April 15, 2009

ETF Warnings

My previous post outlined two reasons why ETFs might be more attractive than traditional low-cost indexed mutual funds.  Here are some down-side risks to check for.

Does This ETF Suck?

This isn't a risk unique to ETFs - there are lots and lots of lousy mutual funds too.  But suffice it to say, the biggest risk with an ETF is that it isn't a very good one.  Check the expense ratio, and make sure the index makes sense for your investment goals.  There are actively managed ETFs, custom-indexed ETFs, high expense ratio ETFs - lots of weird stuff.

Brokerage Fees

ETFs are "more fair" (IMHO) than mutual funds because the cost of buying and selling the shares is out front where everyone can see it: you pay a commission to buy or sell an ETF, just like you would a stock.

But this means you have a fixed cost per transaction, and this changes things compared to a mutual fund.  For example, if your 401k normally buys a small amount of 4 mutual funds every pay period, that's 104 transactions a year.  At $12.50 a transaction, you've paid $1300 in brokerage fees.  If you contribute the IRS maximum ($16,500) that's a 7% commission!  Ouch!

Simply put, heavy dollar-cost averaging over a wide number of funds isn't going to be cost-effective with ETFs.  To use ETFs, you need to make contributions in fairly large chunks.

It should be noted that mutual fund buys are not really cost-free; the mutual funds that you can buy through your broker without a sales fee are subsidized by the mutual fund itself.  Example: I can buy any Fidelity mutual fund for free via my Fidelity account because Fidelity's mutual funds have an agreement with Fidelity's brokerage.  If I buy a Van Guard mutual fund I pay $75 - way worse than a trading commission.

Typically mutual funds that are free to buy will have a higher expense ratio - part of the expense ratio will go back to "mutual fund supermarket" brokers (like Fidelity, Charles Schwab, etc.) to offset buying costs.  There is no free lunch.  (One possible exception: Fidelity heavily subsidizes its own Spartan index funds to keep the expense ratios competitive with Van Guard.  So there may be some loss leader mutual funds.)

The bottom line is: your buying pattern may have to change to use ETFs, and there is a cost to not dollar-cost averaging, so look at the big picture and the details.

The Bid-Ask Spread

Since ETFs are traded, there is a bid-ask spread - that is, the price you sell at will always be a tiny bit lower than the price you buy at on the exchange.  That spread is the profit that market makers get for providing liquidity (that is, buying and selling whenever people want to keep the market working).

A healthy ETF should have high liquidity and thus a very narrow bid-ask spread.  For example, IVV (an iShares S&P 500 ETF) has a 1 penny bid-ask spread on an $85.51 share price - that is, the spread is really, really tiny.  If the ETF is less liquid, traded less often, has fewer shares, etc. you might see wider spreads.

If the bid-ask spread is too wide, treat this like an expense; you will lose the spread each time you buy/sell.  If an ETF were to have a 1% bid-ask spread, you'd lose 1% when you buy and sell.

(A one-time loss is not as bad as recurring fee like expense ratios, but it does warrant examination.)

Arbitrage Failure/Tracking Error

When you buy some shares of an open-ended mutual fund (most mutual funds are open-ended), the mutual fund manager goes out and buys some stock (or bonds or stuff) - in other words, crunch all you want; when you buy, the manager makes more.  To understand the problem of arbitrage failure in ETFs, we have to first ask: where to ETF shares come from.

When you buy and sell shares of an ETF, you are simply buying or selling existing shares on an exchange.  But...what if everyone wants shares of IVV (an S&P 500 index ETF) at once and there just aren't enough? What keeps the price of IVV from skyrocketing above the S&P index that it should track due to the outsized demand?

The answer is in the way ETF shares are born: in-kind creation and redemption.  ETF shares are created by someone coming to the ETF with the underlying stock or bind and saying "convert these stocks that make up the S&P into ETF shares".  The ETF takes the stock and holds onto it (that's what the ETF does) and issues brand new shares.  There are now more ETF shares in existence but the ETF now has more underlying stock to back them up.

Now when someone does an in-kind creation or redemption, he or she will make a profit or loss based on the difference between the ETF share price (as traded on the market) and the price of the underlying stocks and bonds that make up the ETF.  This is what keeps an ETF's price so close to its underlying value ("net asset value" or NAV).  

If the ETF share prices were ever selling for a lot more than the underlying stocks, some clever investor could buy the stocks and sell the ETF at the same time (making a profit).  To then recover the sold ETF shares, the investor simply converts the bought stock to ETF shares.  In other words, if the ETF trading price diverges from the NAV price, there is an arbitrage opportunity.  Arbitrage keeps ETF trading and NAV prices in sync, and that's why your ETF shares are always worth the value of the underlying assets.

Well, almost always.  During the recent market crisis, some ETF shares were trading at less than the value of their underlying assets.  How did this happen?  Vanguard explains here.

Basically if the NAV of an ETF share is below the trading price you don't want to buy (you'd be over-paying) and if the NAV of an ETF share is above the trading price you don't want to sell (because theoretically you should be able to get a better price).  In practice, you're most likely to see this with bond funds, where the market for selling the underlying assets (bonds) is (a) not very fast/transparent like a stock exchange and (b) tends to seize up periodically these days.

ETFs introduce one last potential risk: you.  If you are the kind of person who might be tempted to day-trade your index funds, if  given the tools to do so, you might not want an ETF. Mutual funds are fairly clunky to buy & sell - they're terrible for day trading and speculating. ETFs don't have this weakness - you can short them, trade them every 3 minutes, and probably even buy them on margin.  If the temptation is too much, an ETF might not be a good idea.

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