Exchange Traded Funds

EXCHANGE-TRADED FUNDS

Mutual funds and exchange-traded funds have many similarities. A previous blog this month covered mutual funds, and now it’s time to talk about the newer kid on the block—exchange-traded funds or ETFs.

I was part of the institutional sales force at Vanguard when that company decided to expand its offering of ETFs and market them to advisors. It was an exciting time! Vanguard is well known for its mutual funds (you may have some offered in your company retirement plan) but the use of ETFs was not widespread. How that has changed—ETF use has grown exponentially!

When they originated, ETFs held only stock and bond index funds. (See last week’s blog, Mutual Funds, for a discussion of active and passive management styles.) Since then, not only the number of ETFs available in the marketplace, but also the types of products an investor can buy via an ETF has skyrocketed. You can buy anything from commodities to currencies, as well as subsets or combinations of stocks and bonds for different strategies just like mutual funds. Some ETFs even use active management. More and more actively managed ETFs enter the market each year.

Exchange-Traded Funds
Although they had their genesis in the late 1980’s, the first widely traded ETF (the S&P 500 SPDR) came to life on January 23, 1993. It became the largest ETF in the world. ETFs contain many different securities, like mutual funds, but ETFs are not sold directly by mutual fund companies. Instead, ETFs are purchased and sold via a stock exchange, and you must place trades to buy or sell through a brokerage account like you do stock. Although that typically means you would pay a sales charge or commission to a broker, many firms now offer free trades for some ETFs (and stocks, too). ETFs were created to buy and sell index mutual funds during the trading day instead of waiting until market close. That provides an investor with greater liquidity and more control over the time and price of a trade. What do I mean by that?

Trading Mutual Funds and ETFs
Mutual fund shares are priced once a day after market close. The closing market price of each security in the fund is added together, the liabilities of the mutual fund (its expenses and operating costs) are deducted, that amount is divided by the number of shares outstanding and the result is the net asset value or NAV per share. When you place an order to buy or sell a mutual fund, you do not know the exact price because trade orders must be placed before market close, and the pricing of mutual funds takes place after market close. Purchases and sales of mutual fund shares are placed directly with the mutual fund company, not through an exchange. Even if you buy a mutual fund via a brokerage account, the brokerage firm will combine all customer orders for the fund and place those orders once a day directly with the fund. A mutual fund will always trade at its NAV.

On the other hand, ETFs trade on a stock exchange all day long, so the market value of the ETF is not only adjusting to the changes in the market prices of the underlying securities—stocks and bonds for example—but also to supply and demand of the ETF itself. Although it adjusts quickly, the price of an ETF may occasionally be more or less than its NAV. If the stock market starts tumbling during the day and you panic and want to sell, you can enter a market order to sell your ETF and it will be completed at the current market price almost immediately. If you enter your order to sell your mutual fund at the same time and the market continues to tumble, its price may be substantially lower because the sale price for the mutual fund will not be set until the end of the day, after market close. For investors who are in the market for the long haul, however, the timing of a trade during the day is not a big concern.

The money to pay for a mutual fund will be taken out of (or if it’s a sale, be put into) your account the next business day, in most cases. Mutual funds vary in the minimum amount you need to invest. An initial investment is usually $2,500 to $3,000 but can be as low as $500. Subsequent investments are much less, $50 or $100, for example. You can also set up for dollar cost averaging, automatic investments at regular intervals, with most mutual funds.

Where mutual funds set a minimum purchase and reinvestment amount, you can buy as little as one share of an ETF. However, you can buy fractional shares of a mutual fund but not an ETF. Another consideration is that the money settlement for ETFs, like stock, is trade-date plus two days. You wait longer to get your money if you are selling an ETF.

Expenses
ETFs usually have lower, sometimes much lower, operating expenses than a comparable mutual fund and that is a big advantage. More of your money is going to work for you! Also, due to the structure of an ETF, it may be more tax-efficient than a mutual fund.

You can usually buy mutual funds directly from the creating investment company, but not always. Some mutual funds are only offered via a broker-dealer. Therefore, buying a mutual fund directly from an investment company is kind of like buying wholesale, while buying via a brokerage firm is more like buying retail. Most retail stores will add a sales charge to the wholesale price of an item and that is true of mutual funds too. If you want to buy a variety of mutual funds, however, you have more choices through a brokerage account and that will save you time.

All ETFs are purchased through a brokerage account because they trade on a stock market. In addition to the purchase price of an ETF, there may be additional expenses. Check to see what charges or fees are involved before you select a particular brokerage firm. Here are common ones:

  • administrative or custodial fees: fees to cover the cost of record keeping, reporting, and safekeeping
  • sales charges/loads or commissions: charges assessed with the purchase or sale of certain products
  • advisory fees: cost of professional advice or ongoing management

Some of these expenses are reported separately and are readily available, and some take a little more work to find. Some are charges associated with an ETF and some are associated with the broker or broker-dealer firm. Ask how you will be charged and what fees and expenses to expect. This is important! To maximize your success, you want as much of your investable dollars to be used to purchase investments and not to pay fees and cover expenses.

Here is a chart comparing the major differences between mutual funds and ETFs:

COMPARISON OF MUTUAL FUNDS AND ETFS

  MUTUAL FUNDS EXCHANGE-TRADED FUNDS
MANAGEMENT    
     Styles Active and Passive Passive and some Active
TRADING    
     Order Placement Orders placed directly with the fund Through an exchange
     Purchase Initial and subsequent $ minimums One share/no fractional shares
  Possible minimum hold time No min. hold time (Beware wash sales!)
     When Priced Once a day, after market close Constantly throughout the trading day
     Settlement Usually next business day after trade Two business days after trade day
     Price Net Asset Value Usually Net Asset Value
     Time/Price No control by investor Investor can control time/price of trade
     Costs Possible front or back-end sales load Possible commission
  Possible redemption fee  
  Possible short-term trading fee  
OTHER FEES    
     Account N/A Possible brokerage admin or custodial
  N/A Possible advisory fee for brokerage acct

Which do you like better—ETFs or mutual funds? Both have a wide range of choices covering almost all types of investments. You may want to combine the use of ETFs and mutual funds. If you decide to do that, the easiest way is through a brokerage account. Make sure you understand all the associated account expenses and fees, in addition to product related fees and restrictions. And don’t hesitate to compare different brokerage houses to find the best fit for your needs.

Please do not hesitate to send me your questions about mutual funds and ETFs. Also, my book, How to Dress a Naked Portfolio: A Tailored Introduction to Investing for Women, contains examples of how to use ETFs and mutual funds to create a unique portfolio just for you.

Until next week,

~Bev Bowers, CFP®

 

Legal Notice: This document is intended to be informational only. Beverly Bowers does not render legal, accounting, or tax advice. Please consult the appropriate legal, accounting, or tax advisor if you require such advice. The opinions expressed in this report are subject to change without notice. The information in this report is from sources believed to be reliable but are not guaranteed to be accurate or complete. All publication rights reserved. Use of this material is subject to the Copyright restrictions described on BevBowers.com.

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark and the CERTIFIED FINANCIAL PLANNER™ certification mark in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.