Monday, April 13, 2009

Two Reasons to Consider ETFs

I am assuming that you already use low-cost indexed mutual funds, and assuming retirement planning (e.g. ignoring taxes).  Here are two reasons to use low-cost index-based exchanged traded funds (ETFs).  I am not arguing in favor of high cost ETFs (they do exist!) or some of the weirder indices (people make up indices and build ETFs around them all the time) - this is just a comparison of mutual funds vs. ETFs for things like the S&P 500.

WTF is an ETF?

Here are two articles explaining (or trying to explain ETFs).  But the basic idea is this: an ETF is like a public company whose business is to simply own the stocks (or bonds) in the index it tracks.  Since the company doesn't really have a business plan other than holding these stocks or bonds, the share value of the company is pretty much equal to the assets inside it.  Thus you can trade a single "stock" (the ETF shares) on an exchange instead of trading the 500 stocks that make up the S&P.  In other words, ETFs are sort of "meta-stocks".

How is this different from a mutual fund?
  • In a mutual fund, when you buy & sell shares in the mutual fund, the mutual fund buys and sells the underlying "stuff" inside the fund to raise the cash to give you your proceeds when you sell, and then buys more stuff when you give them cash to buy.
  • In an ETF, you actually buy and sell the ETF shares itself - the stocks inside the ETF don't have to be unbundled, sold separately, then rebundled each time a share of the ETF is sold.
This structure turns out to be good in two ways...

ETFs Often Have Lower Expense Ratios

When I went looking for a broad bond-index mutual fund a few years ago, I couldn't find anything cheaper than an expense ratio of 0.45.  For a bond fund, that's not very good - if I am only going to earn 3%, I don't want 15% (!) of my profits going to the managers.  You can find bond ETFs with expense ratios a lot lower - more like 0.11%.

There are a number of reasons why ETFs might have cheaper costs:
  • The market is very competitive and very hot.
  • The structure may actually be cheaper to work with.  When ETF shares change hands, only the ETF shares get sold, not the underlying instruments.*  So it is possible that ETFs are less costly to run.
  • Mutual funds have this ugly property: if I sell all my shares and get out of Fidelity's Super-Actively-Managed-Wicked-Indexed-Cool-Kids-Fund (SAMWICK?!?) and you have shares, the fund pays the brokerage fee for the sale out of the fund.  But wait ... you own the fund and I don't.  You just paid my brokerage fees.  Sucker!
  • By comparison, if I sell my ETF shares, I pay a brokerage fee to sell (like I would a stock). I pay my own costs.
On this last point, I would say the cost structures of ETFs are more fair - but it also means that the expense ratio of an ETF doesn't tell the whole story.  (Nor does the expense ratio of a mutual fund - more on that in the next post.)

The bottom line here is that if you are shopping for cheap indices to hold, the best deals seem to be in ETFs.  Van Guard has a nice set of low-cost ETFs wrapped around a number of indices -they are liquid (mostly), well funded, and have very low expense ratios.

More Control Over Buying and Selling

The way the two-step buying process of a mutual fund (step 1 - buy the fund; step 2 - the fund buys more "stuff") is implemented in the US is really lousy: I put a buy order in during the day, then the market closes, then they recalculate the fund price, and then they buy for me at the new price.*  In other words, there is a huge delay in order execution.

That didn't bother me three years ago, but times have changed, and the market jumps up and down several percentage points in a single day.  And that's where another feature of ETFs is handy: the ability to execute trades faster and place limit orders.

Since an ETF is traded like a stock, all of the things you can do with a stock are available on the ETF - in particular, you can place a limit order, saying "I would like to buy 1000 shares of this ETF when and only when the price dips below $50 a share".  You set the limit order and walk away, knowing that if the ETF falls in value (altering the balance of your portfolio) the limit order will (hopefully) kick in and change your asset allocation back to where it should be.

(In my experience limit orders don't work as perfectly as you might hope - I don't know what kind of mechanism is behind the execution process, but exchanges aren't perfectly continuous - there will be a limit to the precision of order execution.)

Similarly, if you place a market order on an ETF, it's going to go through pretty fast.  So in volatile times, with an ETF at least you know what you're buying.

ETFs also have some potentially negative features, and they're a bit more subtle than an ETF's features.  I will cover them next.

* The mutual fund situation is worse - since the NAV is calculated after hours, you only know the NAV if you buy after hours - but if you do that, they wait an entire market cycle.  So you basically never know what you're getting unless you calculate NAV yourself right before the close of market.

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