How ETFs have been oversold when it comes to flexibility, lower costs and tax efficiency

Brooke’s note: There is no doubt that if investment products could wear halos that exchange traded funds would be fitted with them first. Their low costs, high diversity, tax efficiency and the ability to trade them like a stock win them many fans. So it was a bit of a shock that ETFs were associated with the many of the trading snafus that occurred on Thursday when the markets went a bit haywire. To read an article that goes in to some of those issues, click here. But before any of that had occurred, Adam Bold, a seasoned radio host who is unafraid to take controversial stands, was busy working on this column that raises questions about whether ETFs are all they’re cracked up to be. Interestingly, he was especially raising questions about how well ETFs trade.

To read advertisements and news reports about ETFs, an investor could easily come away thinking ETFs are some new investment vehicle offering benefits other types of mutual funds do not and at no additional cost. If that were true, ETFs would be the pot of gold under the rainbow, the truly free lunch. There’s a saying that there is no such thing as a free lunch. There never has been, and ETFs offer no free lunch.

At The Mutual Fund Research Center®, the research arm for The Mutual Fund Store®, we routinely search the universe of mutual funds to find the best investment vehicles to recommend. ETFs are included in this search. Our research has shown that the flexibility, transparency, low cost, and tax efficiency touted as benefits of ETFs are either offset by other costs of ETFs or are not meaningful benefits for the individual investor.

What is an ETF?

ETFs are a type of mutual fund. The vast majority are close cousins of index funds: they hold baskets of stocks and bonds in appropriate proportions to match an index they target. When investors buy shares of an ETF, they buy shares of ownership of that underlying basket of stocks and bonds, just as they would with an index fund. The shares are bought and sold on a stock exchange, which is why these funds are called “exchange-traded funds.”

Flexibility?

ETFs are promoted as more flexible than other funds. Flexibility is generally good. It’s great for gymnasts and rubber bands. For investors, ETFs offer the flexibility to trade shares all day, at whatever the market price is when the trades execute. In contrast, with mutual funds investors place their trades, but the price at which the trade occurs is whatever the fund’s net asset value (NAV) is after the close of trading that day. The NAV is the value of all the fund’s portfolio holdings, less its liabilities, per share of the fund outstanding. The claim that ETFs are more flexible and thus more transparent than mutual funds is rooted in the up-to-the-minute pricing of ETF shares versus end-of-the-day pricing of other mutual funds.

Don’t be too quick to agree that ETFs are more flexible. With a mutual fund, an investor never buys or sells shares at a price different from the fund’s NAV. That is not the case with ETFs. Investors can pay a premium for the shares—more than the NAV—or sell their shares cheaper, at a discount to the NAV. And even though the current price is visible, no matter how disconnected from the fund’s underlying holdings, it could take time for a trade to execute, depending on how liquid the market for the shares. The price could change in that period, leaving the investor just as uncertain of the ultimate price as with a mutual fund purchase. An investor could place limit or stop-loss order to buy or sell shares only within a certain price range, but even then there is no certainty of the price when the trade executes. This is especially true of newer and smaller ETFs and ones that hold bonds or stocks traded in markets that are not as liquid. ETFs that hold bonds or small cap stocks are examples. Beyond that—and perhaps more important—the market price of ETFs could be subject to manipulation, given their often limited liquidity.

Even without this lack of transparency in the price of ETF shares, the ability to trade them at prices that vary during the day is beneficial only if investors trade intraday. That is way too much trading for the average investor. Long before ETFs became popular, research showed that investors trade too much. After allowing for reasonable trading (for example, to raise cash for expenses, to rebalance portfolios), investors were found to trade so frequently that their trading costs ate into their returns. ETFs, with their moment-by-moment price fluctuations, tempt investors to make emotionally driven trades they would be better off without. In fact, TrimTabs Investment Research released a report indicating that ETF investors are “exceptionally poor market timers,” and “impressively wrong in both directions.” The research went on to say that ETF traders are actually indicators of what not to do. Considering this, ETF flexibility is even less of an advantage.

Stacey Schreft: Sometimes an ETF will
make capital gains distributions where a
mutual fund tracking the same index
will not, making the ETF less
tax efficient than the index fund.

Low cost?

ETF proponents highlight ETFs’ lower cost compared to other mutual funds. Because ETFs are like index mutual funds, there is no stock selection required to operate them. The fund company buys shares of each holding in the index in the proportions in the index. This can be done by a computer and so at very low cost. It allows ETFs to charge operating expenses near what index funds charge.

Operating expenses, however, are not the only cost of investing in an ETF. Because ETF shares are traded on stock exchanges, they must be bought and sold through brokerages. Investors incur the same transaction fees they would for buying or selling a stock, about $9 per trade today. The smaller the purchase or sale, the larger the $9 fee is as a share of the transaction. For the small investor, these fees can add up — especially if the investor takes advantage of the ability to trade intraday. These higher trading costs will offset in whole or part ETFs’ lower operating costs. What is not factored in? Opportunity costs. Most ETFs are not managed, and a good fund manager finds ways to add alpha.

Tax efficiency?

A final advertised advantage of ETFs is tax efficiency. This claim is overstated. Ultimately, what matters are net returns, not costs. An investor that sells ETF shares and has profited from holding the fund incurs a capital gain that is taxed like any other capital gain. Also, an ETF must buy and sell holdings when the index it tracks changes so its holdings match the index’s. This can cause the ETF to incur capital gains that it must distribute to shareholders just as a mutual fund would. Sometimes an ETF will make capital gains distributions where a mutual fund tracking the same index will not, making the ETF less tax efficient than the index fund. For example, Morningstar estimates the iShares S&P 500 ETF to be much less tax efficient than the Vanguard 500 mutual fund.

Our advice

We do see benefits of ETFs for large institutional investors like mutual funds and hedge funds. ETFs facilitate their use of some sophisticated trading strategies, strategies the average investor is not equipped to implement. Investors who dive into those waters are swimming with sharks, without shark teeth to protect themselves.

Adam Bold is Chief Investment Officer and Stacey Schreft is Director of Investment Strategy of The Mutual Fund Research Center®, an SEC registered investment adviser which provides mutual fund and asset allocation recommendations and research to stores in The Mutual Fund Store® system. Past performance cannot guarantee future results. Investments in securities, including mutual funds, involve the risk of loss.