Sunday, April 22, 2007
The ETF Advantage
The Economist has a short piece on the ETF movement leading this week's Finance and Economics section. Proponents (Lee Kranefuss at Barclay's Global, e.g. http://www.indexfunds.com/articles/20000925_kranefuss_iss_int_LK.htm) tell us that ETFs essentially offer the same advantages that a mutual fund tracking a particular commodity, market, industry, etc., would. The difference highlighted in the Economist article is that ETFs offer prices that fluctuate throughout the day and are as such rebalanced more aggressively throughout the day than mutual funds. It is suggested that even though this rebalancing calls for more active management, the management that is called for is less expensive than that of mutual funds (beta is cheaper than alpha). So the advantages seem clear. The Economist article lists the notable drawbacks as well. Lack of liquidity due to an ETF following a niche market seems to be an important one. The other drawback that is featured in the article is the tendency for ETF share prices to diverge from their target due to purchase of too concentrated a portfolio. For instance, an oil industry ETF might diverge from its target if it invested too heavily in a particular company, e.g. Shell, which then experienced an event very specific to Shell that caused its share price to move against the rest of the industry.
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3 comments:
I haven't seen The Economist article, but a couple of things here don't jive with what I think I know about ETFs.
Real-time pricing is an advantage to the investor not because the ETF is rebalanced throughout the day but because it provides far greater liquidity on both sides of the market. The substantially lower fees associated with ETFs as compared to mutual funds corroborate that more active management is not a defining feature.
Following a particular market or commodity does not reduce liquidity, it reduces diversification.
It strikes me that The Economist overlooks some of the other key advantages to ETFs. Namely, ETFs allow short selling and stop loss orders, both manifestations of greater liquidity. Additionally, there are some rather technical tax advanatges pertaining to capital gains distributions.
Likewise, the article overlooks the salient cost of ETFs as compared to mutual funds, which is that brokerage costs are incurred on every trade. Another significant difference between a mutual fund and ETF is that like equities you have to own whole shares, not whole dollars. Some ETFs have more restrictive requirements than single shares.
Comparing ETFs only to mutual funds does not do them justice. Instead, they should be compared to both mutual funds and individual stocks. While cost structure and liquidity is comparable to stocks, ETFs have the advantage of diversification.
You should read for yourself and make sure that your criticisms are not simply due to omission on my part. I like most of what you said but I'm going to call for elaboration on your second paragraph. Not sure I get what you're driving at.
This is how a regular mutual fund works. All day long, individual stocks that are part of the portfolio move up and down. The fund managers buy and sell these stocks to adjust the portfolio. The more they buy and sell, the higher the fund fees. This is why index funds have lower fees than actively-managed funds. At the end of the day, the whole portfolio is priced. Any investor who buys or sells fund shares during the course of the day buys or sells at the closing price.
An ETF operates conversely. The managers select a bunch of stocks to peg a target. As those stocks fluctuate through the day, individual investors choose to buy or sell shares in the ETF with real-time pricing. The management stays out of it--thus the much lower fees for an ETF. This liquidity is obviously a huge advantage for the individual investor on both sides of the market. When the management adjusts the contents of the portfolio, they can pass the shares through to individual investors, thus no capital gains distributions.
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