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What You Need to Know Before Buying ETFs

Thu, 5 Nov 2015

Transitioning from mutual funds to ETFs for their low costs and tax efficiency is tempting, but some of these advantages may be exaggerated, says Vanguard's Joel Dickson.


Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Exchange-traded funds have taken off in popularity, leaving many investors to wonder whether they should abandon their traditional mutual funds in favor of ETFs. I recently sat down with Vanguard's Joel Dickson to discuss the factors they should consider first.

Joel, thank you so much for being here.

Joel Dickson: Thank you for having me.

Benz: There has been a stampede into exchange-traded funds, and certainly there are some benefits touted. I'm wondering if we could talk about what you view as the key advantages of ETFs versus traditional mutual funds and then maybe some of those advantages that perhaps are a little bit overblown, especially depending on what type of investor you are.

Dickson: I think there's been a lot of discussion certainly about ETFs and funds, and I think a lot of times there is confusion about what truly are the differences. The main difference is really one about how people access the shares. With a mutual fund, you are investing directly--or maybe your advisor is investing directly--with a mutual fund company, whereas with an ETF, it's largely through a secondary market--on the brokerage or on the exchange--where investors are buying and selling shares. And that leads to some differences in the accessing of the shares themselves.

Ultimately, whether it's an ETF or it's a mutual fund, they are wrappers for underlying investment strategies. And by and large, the majority of ETF investment strategies have been index-based--they are seeking to track an index of some sort, whether it is a standard cap-weighted S&P 500-type index or whether it might be so-called strategic beta or smart beta alternative indexes. It's what we would call rules-based active approaches. By and large, however, the traditional mutual fund industry has been built up from a sort of active-management standpoint. So, still, the typical mutual fund is a security-selection active-management investment approach; the typical ETF may be an index-based approach. That's part of the issue of is it ETF versus fund or is it active versus passive, and I think a lot of the discussions of the advantages--or supposed advantages--of ETFs are not so much about ETF versus fund, but rather active versus passive.

We talk about ETFs as potentially being lower cost or potentially having a little bit better tax efficiency, and while there may be some mechanics in the ETF that work a little bit differently that can enhance tax efficiency at the portfolio level, by and large, what we know from the traditional mutual fund universe is that index products compared with similar active products have at least historically tended to be more tax-efficient. So, is it an index/active story or is it an ETF/fund story? And that goes also along the lines of cost.

In fact, we did some research a couple of years ago that showed that the average expense ratio in index mutual funds is actually lower than the average expense ratio in ETFs. But yet, overall, if you just take the category of mutual funds, ETFs are lower cost than mutual funds; but when you compare index to index, actually traditional mutual funds on average were lower. So, it's not so much this ETF/mutual fund story as it is active/passive; it's the underlying investment strategy and how you access that.

Benz: You've hit on costs a couple of times, and certainly when anyone's looking at any type of index product--whether traditional index mutual fund or ETF--that's an important consideration. But one thing you wrote about in a recent research paper was this idea of the various costs that you pay as an investor--the direct fund expense ratios as well as trading costs that you might incur. You had a nice grid in the paper where you helped investors think about their break-even costs and how these two sets of costs work together. Can you walk us through the thinking behind that grid and how investors can sort of put this decision-making into action?

Dickson: Sure. There are really two separate categories of cost that you think about with ETFs, funds, investment products. One is the ongoing costs--think of that simply as the expense ratio. You pay that each and every year. Then there's the acquisition cost or the transaction cost, and you pay those at the time that you are transacting or acquiring or selling shares. So, it may be that the mutual fund, let's say, for example, has a higher expense ratio than an ETF that you're looking--both have similar strategies. But you may have to pay more to acquire shares of the ETF because you are doing it on a brokerage platform--you may have bid-ask spread costs, you may have commission costs in some instances.

So, how do you compare, then, the total costs of buying and selling the ETF, knowing that the transaction costs at the time are higher, but the ongoing costs are lower? In that case, there is a break-even; if you're holding it for a short time period, you're not going to get the benefit of the lower expense ratio over time, and it will be dominated by the higher current transaction costs.

On the other hand, the longer that you hold it, the more that you, in essence, are spreading those transaction costs over the longer holding period, and then the expense ratio difference can then make a larger difference. So, that table that we have in the research paper looks at different combinations of the differences in expense ratios versus transaction costs. And to a certain extent, you can look at this break-even by considering any two investments. They could be ETF versus fund; they could be ETF versus ETF; they could be fund versus fund.

Just looking at the difference in expense ratios divided by the difference in transaction costs--where both are, say, a percentage of the investment or basis points--gives you the break-even in number of years for which of those two products would be more advantageous given the holding period that you expect for your investment.

Benz: That's a helpful rule of thumb. One other topic I want to cover with you is this idea that traditional mutual funds have trading costs, too, that are not reflected in their expense ratios, whereas if you're buying and selling ETFs, you are bearing some of those trading costs yourself. Let's talk about how investors can think about and potentially unpack that question.

Dickson: That's a very important distinction because this often shows up in periods where you'll see changes in liquidity in the underlying securities of an ETF and a mutual fund. So, there's the idea that the net asset value of the fund reflects the current value of the securities--and net asset value is computed for ETFs, computed for funds, and so forth. The market price, or the transaction price, of the ETF on the exchange can actually differ from the net asset value, or the value of the underlying assets for any number of reasons, but the major reason is that the ETF investor is bearing the full extent of their transaction costs.

So, if I buy ETF shares and somebody else on the exchange has sold them to me, there's actually no portfolio impact on that. So, if I sold a share of VTI and somebody else bought a share of VTI from me, the portfolio of our total stock market fund is actually not affected because there was no transaction at the fund level. But there are transaction costs from market makers or from the ability to acquire the underlying securities of the basket and what those costs look like, and there are times when those will vary. And because of that, the difference between the market price of the ETF and the net asset value--or the value of the underlying securities--can vary based on changing cost parameters. We see this in the fixed-income space occasionally, where there might be liquidity concerns about fixed-income instruments. And what that means is that the price for liquidity has increased.

So, if you're trying to sell when everyone else is trying to sell, to get somebody to buy that, you're going to have to pay a liquidity premium. That means probably paying a discount to the fund's current net asset value to get somebody to come in and be able to take that liquidity. So, in the traditional fund, if a bunch of shareholders from a mutual fund are selling, the portfolio manager is now selling those fixed-income instruments. And while they will also--if it's more costly to sell--realize that additional cost in selling, it's going to show up in the net asset value, not in the difference between, say, the transaction (because there's no portfolio impact) and the net asset value, as it would with the ETF. The summary is if you are transacting as an ETF investor, you're responsible for the transaction costs that would be incurred on your investment. In a traditional mutual fund, often those transaction costs are spread over the other investors in the fund.

Benz: It's an important--albeit complicated--issue, but I think it's worth taking a look at. I just have one last question for you, Joel. We've seen these periodic market dislocations where we've seen some ETFs trade way out of line, so their market price is way different from their net asset values. How can investors protect themselves in this kind of environment? I'm sure you'd say, "Well, don't be transacting if you can possibly avoid it during such times." But what other steps can ETF investors take to make sure that they don't inadvertently get caught up in one of these bad price dislocations.

Dickson: Because there is this opportunity that the market price may be different from the value of the underlying securities, I think the first thing is to get out of this assumption that I think we all implicitly have that the ETF will always trade right on top of the value of the underlying securities. Yes, there are a lot of mechanisms to try to ensure that happens in as many instances as possible. You hear about the arbitrage mechanism of ETFs--and yes, that should keep things relatively in line. But there are periods--whether it might be different market events or how the underlying securities themselves trade--where you can have some dislocations.

We certainly saw this on Aug. 24 of this year. There was a lot of volatility in the market. We had these relatively new procedures called "limit up, limit down" that affect how much a security can move and whether a security gets halted. This was sort of the first real live test in a volatile market environment since those rules had been put in place. And while they worked as written, it looks like there could be some improvements on how especially ETFs, but even individual securities, work in relation to those types of rules. So, you did see a couple of what might be viewed as strange prints. There are ways, however, as market-structure rules continue to evolve to make sure that that hopefully doesn't happen as much in the future. But regardless, we don't know what the next event will be that might cause a little bit of dislocation.

So, there are things investors can do to protect themselves--and in particular, especially with exchange traded funds. Using limit orders can be a really good protection for investors, because there's really not a lot of debate about what the price of the ETF should be if you know what the price of the underlying security should be. It's an accumulation of those underlying securities--and relative to some transaction costs around that, it should be probably fairly close. And by having a limit order, you can tie that better to the value of the underlying securities and protect yourself from those situations that happen. The other thing is--especially if you aren't using a limit order--when trading at the beginning of the trading day or at the end of the trading day, there can be a little bit more volatility in exchange-traded-fund prices. It's important to understand the trading environment, as well as the underlying investments, if you are in ETFs.

So, the two major things: Use limit orders, if at all possible, and be careful about what time you are trading. And then related to using limit orders, stop orders can be very problematic with ETFs; this is kind of what seems to have occurred on Aug. 24. If you get this downdraft and you've put in a stop order on a particular price to protect you on the downside, stop orders immediately turn into market orders. And if you have an environment like on Aug. 24 where there were a lot of imbalances between sells and buys, that market order that just got triggered may actually push the ETF price down even more--not necessarily help it return to where you might expect it to be relative to its underlying holdings.

So, stop orders can be really problematic, and I think a lot of investors don't necessarily always understand that they immediately turn into market orders once they get triggered. You could actually end up with a fairly poor execution in those situations.

Benz: Joel, some valuable pieces of advice. Thank you so much for being here to share them with us.

Dickson: Thanks a lot, Christine.

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