At Personal Capital, we seek to improve the way people manage and control their money. It won’t be easy, but the financial industry has left the door open to a lot of opportunity. While other parts of the economy spent the last decade creating iPhones and iPads, life-saving drugs, and electric cars, much of the financial world was busy conducting a massive theft from investors and shareholders. They called it Asset Backed Securities and Collateralized Debt Obligations.
Still, there has been some progress. Some of the best innovation in the last ten years has been in Exchange Traded Funds, commonly referred to as ETFs. Their expansion has allowed average investors to get cheap, diversified access to areas of the capital markets that were otherwise difficult to own, especially internationally.
On their own, ETFs are a big improvement over mutual funds – more on why in a little bit. Like all tools, however, they key is how they are used. Not all ETFs are the same, and they can be destructive if not applied with discipline.
What Are They?
An ETF is exactly what it sounds like. It is a pool of money (a fund) used to buy stocks, bonds or other investments. That pool is then divided into shares which are traded on an exchange. When you as an individual investor buy a share, you buy a portion of the fund from someone else on an exchange at an agreed price. When you sell it, it is to another buyer. This is very different from a mutual fund where you buy and sell (redeem) shares directly from the fund itself at a Net Asset Value (NAV).
With ETFs, when there is enough new demand, a block of new shares is created by an investment bank who handles the operational tasks of buying the securities which make up the fund. These same financial institutions can also “unwind” blocks of ETF shares by selling the underlying securities and dissolving the actual ETF shares.
This mechanism allows for easy arbitrage opportunities and ensures ETFs remain fairly priced. It is also an advantage of ETFs over mutual funds, because it avoids unnecessary trading costs related to new cash additions or withdrawals from the fund.
Are They Safe?
Aside from the inherent volatility of the underlying investments, most ETFs are quite safe for investors to own. It is important to remember that ETF shares are backed by the actual assets held in the fund. As long as our capital markets continue to function and the rule of law is maintained, the ownership of your investment will be safe.
If the sponsor of the fund (such as Vanguard, State Street or Blackrock) goes bankrupt, the ETFs will not lose their value. Note that this is not the case for ETNs (Exchange Traded Notes). An ETN is a note (debt) from the issuer, not a fund of assets. Avoid ETNs in general.
It is possible the liquidity of certain ETFs could dry up. For the more popular ETFs tracking the major stock indexes, this will not happen unless the liquidity of the whole market drops. In more narrow segments like high yield bonds or emerging markets stocks, there is short term liquidity risk because the liquidity in the underlying securities could drop, as it did briefly during the crisis in 2008.
A Quick History
The first ETF showed up in 1989, while the first one to survive and grow was SPY, established in 1993. Barclays Global Investors (recently purchased by BlackRock), began manufacturing ETFs based on foreign country indexes in 1996, greatly increasing access to foreign markets for casual investors. State Street introduced S&P sector indexes in 1998. The 2000’s saw an explosion in ETFs. There is now over a trillion dollars invested among several hundred ETFs.
How do They Perform?
ETFs are usually designed to passively track an existing index. Initially, these were broad indexes such as the S&P 500 or NASDAQ 100. Now, there is an ETF for just about every slice of the market imaginable. The passive aspect to ETFs is very important. Most mutual funds are actively managed, meaning someone is trying to make decisions to get better results. This sounds great, but history has repeatedly shown that most active mutual funds ultimately lag their benchmarks. In 2008, the SEC allowed for the creation of actively managed ETFs. It is too early to tell if these actively managed ETFs will be good products. We are skeptical.
ETF portfolio managers attempt to mimic the performance of the benchmark index as closely as possible with as little trading cost as possible. In reality, most funds track closely to the index, but there is some variance, called tracking error. Don’t get too caught worrying about tracking error unless it is consistently negative. The tracking error of a properly managed stock or bond ETF should be very small, and there is roughly an even chance of it helping or hurting.
Technically, an ETF is subject to daily price fluctuations based on supply and demand, like every other security. In fact, the price of ETFs can and do vary from their Net Asset Value. When everyone wants to buy, they tend to sell for more than the price of the underlying securities. When everyone wants to sell, they can trade for less. But these discrepancies usually remain small and don’t last long.
The beauty of the ETF structure is that the exact makeup of the fund is transparent. New shares can be created when there is sufficient demand and shares can be redeemed if there is a desire to sell. Only big players with large amounts of money can buy (create) or sell (redeem) in this fashion, but they are very active in doing so. This means if the price of an ETF moves too far from its NAV, there is an arbitrage opportunity and investors will take advantage of it by creating new ETFs and then selling them (bringing down the price) or buying existing ETFs and “unwinding” them (increasing the price). The process is very efficient.
ETF managers charge for the service, but the cost of investing in ETFs is often quite reasonable. In fact, the lower cost compared to actively managed mutual funds is a primary reason to utilize ETFs. Direct management fees for individual investors usually range from below 0.1%, up to 1.0%, depending on the provider and the complexity of the underlying index.
The Bid/Ask spread should also be checked and considered, but it is usually one cent or less for the more popular ETFs. On a $50 ETF, this is only .02%. Standard trade commissions are typically charged by your broker for ETFs.
Another key advantage of ETFs compared with mutual funds is their tax efficiency. Because ETF shares can be redeemed on their own, and because there is low turnover in the composition of the fund, most capital gains realized within ETF shares are avoided.
You will still have to pay taxes on the dividends and on any realized capital gains when you sell, but it is unlikely you will be faced with a meaningful capital gains distribution from the fund while you hold it. Some ETFs may have capital gains distributions, but they are small and rare.
The Bottom Line about ETFs
ETFs can be very effective tools to gain exposure to certain segments of the capital markets. They generally represent a huge improvement over mutual funds. In our Personal Strategies, we utilize ETFs for exposure to bonds, alternatives (such as commodities and real estate), and some areas of the foreign stock markets.
Like any tool, they must be used properly to add value. Most ETFs follow indexes which, by definition, are not broadly diversified. So it is important to blend ETFs in the right combinations to produce a portfolio with the risk and return characteristics appropriate for you.
Craig Birk, CFP®
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