It was the dot-com boom and I dutifully invested my hard-earned $1,500dollars into JDS Uniphase, only to watch it drop 20% within a few months whenthe market went to pieces. The dot-com boom-and-bust taught me one valuablelesson—stick with index funds, pal.
I love the idea of index funds—they invest in all the companies in anindex, such as the S&P 500. You don’t have to pick the right companybecause when you invest in a single fund, you’re essentially picking them all.
As a young person, mutual funds fascinated me. What could be better thanbuying shares of a mutual fund and pooling my money with other investors whowant their money invested in accordance with a specific investment strategy?And, at the time, they were the only type of fund that could track an index.
Mutual funds are great, but you can only buy and sell after the marketcloses. Getting a price update on a fund only once a day seemed a little slow.Archaic, even.
When I heard about ETFs, which are priced throughout the day, I thoughtthey were a new investment. In reality, the first ETF in the United States waslaunched in 1993—25 years ago!
Thinking of ETFs as a “new” investment was the first of many misconceptionsI’ve had to unlearn!
What are ETFs?
If you know about mutual funds, then an ETF will be familiar. ETF stands for exchange-traded fund. It’s similar toa mutual fund except it’s traded on an exchange like a stock. Since you can buyand sell shares throughout the day, which you can’t do with mutual funds, youcan see the real-time price of the ETF anytime.
ETFs and mutual funds are similar in many ways. Just as there are indexmutual funds, there are index ETFs. Index funds—both mutual funds and ETFs—arepassively managed funds that seek to match the performance of an underlyingindex. An S&P 500 index fund tries to match the performance of the S&P500 Index and it’s one of my favorite passive incomeinvestments.
The biggest difference between mutual funds and ETFs is how often sharesare priced. Mutual funds aren’t traded throughout the day on the open market.When you “trade” shares in a mutual fund, the transaction happens only once aday after the markets have closed. You can trade ETFs on the open marketthroughout the day, so you always know the exact price of a share.
There are many misconceptions about ETFs—I know because I believed a lot ofthem, and today we’ll dispel some of the biggest.
1. ETFs are more volatile
I’m a firm believer that you should buy and hold stock investments for thelong term. A mutual fund, especially a low-cost index fund that only transactsonce a day, feels stable.
Why would I want an ETF that has its shares bought and sold all day? Idon’t want to watch the price change by the minute.
An ETF is just a fund that holds a basket of stocks and bonds that move upand down throughout the day. A mutual fund does the same thing. The onlydifference with a mutual fund is that you only see price changes once a dayafter the market has closed. The value of the mutual fund’s shares changethroughout the day, as its investment holdings’ values change—you justdon’t see it.
An ETF isn’t inherently more volatile just because you can trade it. Itonly feels that way because you see the price in real time. An ETF’s volatilityis based on the securities it holds—if it tracks the same benchmark as a mutualfund, the volatility will be comparable.
2. ETFs are “copies” of mutual funds
I thought all ETFs were exchange-traded versions of an existing mutualfund. For the first two decades, this was mostly true. ETFs were all based onexisting benchmark indexes like the S&P 500 and Russell 2000.
Most ETFs are index funds, but you can get ETFs with a wide variety ofinvestment strategies. There are ETF versions of your favorite index funds,like the S&P 500, as well as bond and stock funds. You can buy ETFs byasset type or sector, like a health care ETF that seeks to match theperformance of the broad industry.
3. ETFs are more expensive
Buying and selling ETFs canbe more expensive because they’re bought and sold like stocks. Each transactionis subject to a commission, which is a fee you may have to pay your broker.
However, many brokers that offer ETFs let you buy and sell some ETFswithout paying a commission. (See this recent poston the Vanguard Blog about commission-free ETFs.) When a brokerageoffers commission-free ETFs, it levels the playing field with mutual funds andmakes ETFs at least as affordable (if not more so) as mutual funds.
Commissions aside, when it comes down to it, an ETF is like any otherfinancial product—price varies. An ETF isn’t inherently more expensive than amutual fund with the same investment objective that tracks the same underlyingindex.
I was surprised to discover that, in many cases, an ETF may actually have alower expense ratio than a similar mutual fund. (An expense ratio is the totalpercentage of fund assets used to pay for administrative, management, and othercosts of running a fund.)
4. ETFs are less tax-efficient
ETFs are bought and sold throughout the day on an exchange, just likestocks. I thought this frequent-trading activity made them less tax-efficient.
In reality, it doesn’t. The shares of an ETF may change hands, but theunderlying assets don’t.
When you buy and sell shares of a mutual fund, the mutual fund’s underlyingassets change, and the fund must buy and sell securities to reflect this. Ifthere’s a significant flow of money in either direction, the mutual fund buysor sells the underlying securities to account for the change.
This activity can create a taxable event. If a mutual fund sells a securityfor more than its original price and realizes a net gain, you (the investor)are subject to capital gains tax, plus the taxes you may owe when the fundmakes a distribution, such as a dividend payment, to your account.
On the other hand, when you buy and sell shares of an ETF, the ETF doesn’thave to adjust its holdings, which could trigger gains and losses. While an ETFbuys and sells its underlying securities as needed, outside forces don’t affectan ETF as easily as a mutual fund. This makes an ETF more efficient under thesame circumstances.
5. All index ETFs are created equal
If you want to buy an S&P 500 ETF, you have many options.
Vanguard S&P 500 ETF (VOO), iShares Core S&P 500 ETF (IVV), andSPDR S&P 500 ETF (SPY) are all ETFs that seek to match the performance ofthe S&P 500 Index. They’re not all priced the same, however.
If you review their expense ratios, you can see a big difference.
More importantly, if you compare the year-to-date performance of each ETF,they may not match exactly. They may not even match the performance of thebenchmark index, the S&P 500. This difference is known as tracking error.
ETFs use different approaches to match what they track. With an index, mostETFs buy the stocks in the index at the proper weightings. As the components orweightings of the index change, the ETF adjusts accordingly, but notinstantaneously. This may lead to a difference in the returns based on howquickly the ETF adjusts.
You might think a positive tracking error is a good thing because thefund’s return is higher than the underlying index. A slight difference isacceptable, but you don’t want a large disparity. The goal of investing in anindex fund is to mirror the returns of the underlying index given its riskprofile. If the fund’s holdings no longer match its respective index, you maybe exposed to a risk profile you didn’t sign up for.
It’s important to review the ETF’s expense ratio and tracking error beforeselecting the ETF you want.
Why doesn’t everyone buy ETFs?
Does it sound like ETFs are amazingly flexible? What are the benefits ofmutual funds?
One big factor in favor of mutual funds is choice. There’s a wider selection of mutual funds becausethey’ve been around longer.
And don’t forget cost, since you’ll usuallypay a commission when you buy and sell ETF shares.
I hope I’ve dispelled a few of the misconceptions you may have had aboutETFs and consider them the next time you think about your portfolio.
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