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Is an ETF a form of Mutual Fund?
No, an ETF is an Exchange Traded Fund. While ETFs have some
similarities to mutual funds, there are also some significant
differences.
Probably the best starting point is to clearly define a mutual
fund. A technical definition, provided by
www.investorwords.com
is “an open-ended fund operated by an investment company which
raises money from shareholders and invests in a group of assets,
in accordance with a stated set of objectives. Benefits include
diversification and professional money management. Shares are
issued and redeemed on demand, based on the fund’s net asset
value, which is determined at the end of each trading session. A
closed-end fund is often incorrectly referred to as a mutual
fund, but is actually an investment trust.”
ETFs on the other hand are defined by www.investorwords.comAnother definition is written by
The Motley Fool, which states, “a mutual fund is simply a
collection of stocks and/or bonds". Most mutual funds are
“actively managed,” meaning the mutual fund shareholders,
through a yearly fee, pay a mutual fund manager to actively buy
and sell stocks or bonds within the fund. Though you would think
that mutual funds provide benefits to shareholders by hiring
alleged “expert” stock pickers, the sad truth of the matter is
that the vast majority of mutual funds underperforms the average
return of the stock market’s returns. Currently most mutual
funds do not make their fees very easy for shareholders to
understand.”
ETFs on the other hand are defined by
www.investorwords.com
as “A fund that tracks an index , but can be traded like a
stock." The most well known ETF is the
SPDR, which
tracks the S&P 500. The Motley Fool writers state, “Probably by
now you’ve heard of these “funds that trade like stocks.” They
all seem to have these cute names – Spiders, Diamonds, Cubes,
WEBS, Vipers, iShares, and so on. But these are mutual funds,
right? The Motley Fool can’t possibly have anything nice to say
about them right? Dead wrong. In fact these products are a dream
– for financial service marketers and for Foolish investors
alike. Oh, there are some negatives, and we’ll discuss those
here, but there is much to like about these products, known in
aggregate as “exchange traded funds,” or ETFs. They have proven
so popular that more than 50 new ones have been introduced last
year, whereas the first ETF, the Spider, was launched in 1993. I
find these investment vehicles to be quite Foolish. They are
low-cost, tax efficient, provide ample diversification among
groupings of large businesses…”
So, what are the differences between
mutual funds and ETFs?
Several. We will focus on costs, tax efficiency, flexibility of
trading, and asset management style.
Costs. First, lets talk about fees. Mutual funds generally have
three types of charges assessed to the investor. These charges
are a one time front end or deferred charge, commonly referred
to as a “load”, expense charges and 12b-1 fees. All funds have
an expense charge, the load and 12b-1 fees are not assessed by
every fund. We have seen funds with expense ratios of over 3%
per year, 12b-1 fees of 1% per year and loads of 5.75%.
As referenced by the Motley Fool, most investors in mutual funds
do not realize the expenses that they pay to invest in the fund.
ETFs also have fees, but they do not have loads or 12b-1 fees.
The expense ratios for ETFs are generally 15 to 75 basis points
(or .15% - .75%). Generally speaking, the expenses in the ETF
are lower than the mutual fund. Please note, however, that
normally there is a commission charged on the purchase or sale
of an ETF, just like there is on the purchase or sale of a
stock. Mutual fund purchases normally charge an upfront sales
charge or “load” and as such do not charge a commission. The
upfront sales charge is almost always higher than the
commissions typically charged on an ETF purchase, however,
frequent buying and selling shares of ETFs will result in higher
charges. For a buy and hold investor who normally rebalances
their portfolio once every 12-18 months, the commissions paid are
typically less than the sales charges or loads paid when
purchasing mutual funds. For a client holding ETFs in our
fee-based account, the commissions are waived in lieu of an
annual fee for the portfolio management and advice. In summary,
the commissions typically paid on the purchase of mutual funds:
the internal fees are almost always considerably less making the
overall costs associated with owning ETFs lower than the costs
associated with owning mutual funds.
Tax Efficiency. If you are an investor in a mutual fund, 2000
will be a hard year to forget. During this year of stock market
decline, most funds lost a significant portion of their value.
Then in January, 2001 the mutual funds sent Forms 1099 to their
investors detailing the capital gain income (either long-term or
as ordinary dividend) on which the investor would be taxed! Tax
return preparers heard an uproar from taxpayers who lost
significant money in the market, and then had to pay tax on
income which they never received. In most cases, the taxpayer
didn’t even receive any cash flow from the fund.
The sad thing is that mutual fund investors pay tax every year
on the gains realized inside the fund, even if they do not
receive any cash benefit. Many investors were not aware of this
tax structure. The positive returns that many funds had
throughout the 1990’s overshadowed the tax treatment.
Vanguard, a mutual fund and ETF provider, summarizes the
taxation of mutual funds as follows: “A mutual fund is not taxed
on the income or profits it earns on its investments as long as
it passes those earning along to shareholders. The shareholders,
in turn, pay any taxes due. The two types of distributions that
mutual funds make are income distributions and capital gains
distributions.
-
Income distributions represent all interest and dividend income
earned by securities, whether cash investments, bonds, or
stocks, after the fund’s operating expenses are subtracted.
-
Capital gains distributions represent the profit a fund makes
when it sells securities. When a fund makes such a profit, a
capital gain is realized. When a fund sells securities at a
price lower than it paid, it realizes a capital loss. If total
capital gains exceed total capital losses, the fund has net
realized capital gains, which are distributed to fund
shareholders. Net realized capital losses are not passed through
to shareholders but are retained by the fund and may be used to
offset future capital gains.
A key component to note is that only net gains are passed
through to investors, not net losses.
As stated on the American Stock Exchange website, ETFs tend to
offer greater tax benefits because they generate fewer capital
gains due to low turnover of the securities that comprise the
portfolio. Generally, an ETF only sells securities to reflect
changes in its underlying index. Exchange trading of ETFs
further enhances their tax efficiency because investors who want to
liquidate shares in an ETF simply sell them to other investors
through exchange trading. Because of this unique structure, ETFs
are not required to sell securities to meet investor cash
redemptions, potentially generating capital gains tax liability
for remaining investors.
Keep in mind that the sale of either a mutual fund or an ETF
will generate capital gains/losses for the investor liquidating
shares.
Trading Flexibility. A mutual fund trades only one time a
day, generally at the close of the market. ETFs can, and do,
trade anytime the market is open. With the volatility we have
seen in the market from 2000 through today, this is a tremendous
benefit. We are familiar with investors who have entered a buy
order on funds at 2:00 p.m. with the Dow down 200 points because
they have been waiting for a significant down day to buy.
However, by 4:00, the Dow has recovered to positive territory.
We have seen investors buying on an up day because they were
waiting for signs of recovery, only to have the markets reverse
at the end of the session. Another significant example of the
difficulty with once daily trading is the aftermath of September
11th, when many investors wanted to get either into or out of
the market as soon as it opened. Mutual fund investments by
their nature resulted in a delay until the end of the day to
trade. While hopefully we will not experience a tragedy on the
scale of 9/11, there are other factors, such as Middle East
issues, inflation reports, unemployment, political issues, etc.
that might warrant an immediate desire to change an investment
position.
Asset Management Style. There are several types of mutual
fund management styles, primarily including active trading in
various sectors or classes and passive management in various
sectors or classes. Active management means that the fund
managers are researching, and buying and selling individual
stocks. In theory, they are buying and selling pursuant to some
type of investment or policy statements. For example, a fund may
have a policy statement indicating that they are going to be
buying and selling aggressive growth technology companies.
Two major concerns with active management are the potential for
the manager to style drift, for example the fund with the
statement regarding purchasing the stocks of aggressive
technology companies may have a manager who is concerned over
the volatility in the tech sector, and therefore starts to buy
more value-oriented stocks. There is nothing wrong with buying
value-oriented stocks, but it should not happen in an aggressive
growth fund. A second concern with active management is that
often the extra cost paid to purchase the expert advice exceeds
any benefit from the active management. Again to quote the
Motley Fool site, “although you would think that mutual funds
provide benefits to shareholders by hiring alleged “expert”
stock pickers, the sad truth of the matter is that the vast
majority of mutual funds underperforms the average return of the
stock market. Over time, because of their costs, approximately
80% of mutual funds will underperforms the stock market’s
returns.”
ETFs are in the process of putting together some actively
managed portfolios, but for the most part the ETFs are index or
sector driven, meaning that the stocks purchased are designed to
track some indicator. The first ETF, S&P Depositary Receipts,
are a good example of how an ETF works. S&P Depositary Receipts,
otherwise known as "Spiders,” represent a single unit of
ownership in the SPDR trust. Units of the trust are bought and
sold like individual shares of stock and they trade on the
American Stock Exchange under the ticker symbol SPY. As the SPDR
trust is a pool of money managed to perfectly mimic the Standard
& Poor’s 500 Composite Stock Price Index, the price of a unit in
the trust is always the current value of the S&P 500 divided by
10. Using passive investing, the investors know what they are
buying, that there will not be any style drift, and that their
portfolio return will mimic whatever indexes they are tracking.
What else should I know? This sounds too
good to be true. What are the drawbacks of ETFs as an investing
vehicle?
One drawback to exchange traded funds is that there is a cost
each time a trade is made, in the form of a brokerage
commission. If a portfolio was going to have a great deal of
trading activity, such as a dividend reinvestment program,
dollar cost averaging or a 401(k) monthly contribution, then the
costs of trading may offset the expense savings available as
compared to mutual funds.
Another concern is that the funds trade on the market, and
therefore may not always be trading at the underlying net asset
value. Research into the pricing of ETFs has generally concluded
that any discrepancy is minor in amount, and usually only lasts
for a short period of time. The risk of pricing errors is much
higher in funds that do not trade regularly, such as certain
foreign ETFs.
What types of ETFs are available?
There are over 300 ETFs available, covering all sectors of the
United States market and several foreign markets including
broad-based equity indexes (such as total market, large-cap
growth, and small-cap value), broad-based international and
country-specific equity indexes (such as Europe, EAFE, and
Japan), industry sector-specific equity indexes (such as
healthcare, energy, and real estate), U.S. bond indexes (such as
long-term Treasury bonds and corporate bonds). Please contact
one of our representatives for a current listing of ETFs
available.
O.K. ETFs sound great, but why don’t I
just buy individual stocks?
Diversification, diversification, diversification.
Because each ETF is comprised of a basket of securities, it
inherently provides diversification across an entire index.
Studies have shown that diversification accounts for the vast
majority of overall return in a portfolio. Please ask one of our
representatives for our white paper on diversification and
portfolio return.
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