Introduction to ETFs
Exchange-traded funds (ETFs) have become a very popular investment vehicle since their introduction in 1993. According to Bloomberg, “ETF investments now make up about 28% of total US fund assets, up from around 20% five years ago.” ETFs have been taking assets away from mutual funds for years, and the pace accelerated in 2022, with ETFs gathering $588 billion in assets and mutual funds losing $950 billion.
Investors are increasingly preferring ETFs for some very compelling reasons, including cost, convenience, and taxes, which we will explain.
But first, what exactly is an ETF? Like mutual funds, exchange-traded funds (ETFs) offer investors a convenient way of owning a portfolio of securities. The main difference is that mutual fund investors deal directly with the mutual fund issuer, whereas ETF shares are traded on stock exchanges. To buy an ETF requires opening a brokerage account. Unlike mutual fund shares which must be bought or sold at the end of the trading day at the fund’s (unknown) daily net asset value (NAV), ETF shares trade at known prices throughout the trading day, prices which may be slightly more or less than the fund’s NAV. (Arbitrage opportunities keep ETF prices very close to fund net asset values nearly all of the time.)
Most people use the term “ETF” as shorthand to connote all exchange-traded products (ETPs). ETPs actually include two different fund types:
Exchange Traded Fund (ETF). ETFs have one of three different legal structures: 1) unit investment trust (UIT), 2) open-end registered investment company (RIC), or 3) grantor trust.
- The oldest and largest ETF, SPDR S&P 500 ETF (SPY) is a unit investment trust (UIT). UITs are required to fully replicate the underlying index by owning literally every security in the index. It was easier to get SEC approval for this constrained structure.
- Today, the vast majority of ETFs are registered investment companies (RICs). This is the same structure that most mutual funds have. RIC ETFs have more portfolio management flexibility in that they are able to own a subset of the underlying index and still be considered an index fund. They typically use optimization or statistical sampling techniques to match the characteristics of the index.
- Physical commodity ETFs are usually grantor trusts wherein each ETF share represents an undivided fractional interest in the physical commodity owned by the fund. For example, SPDR Gold Shares (GLD) is a grantor trust.
Exchange Traded Note (ETN). ETNs do not actually own any securities. Instead, they are an unsecured debt obligation of an issuer that promises to pay the holder the total return of an underlying index or other benchmark after subtracting fees. As such, investors are exposed to the creditworthiness of the issuing entity, usually a large bank. Because ETNs are debt obligations, if they have been held for at least one year, ETNs that are sold are subject to long-term capital gains taxes. ETN structures are most often used for investments that are highly illiquid in order to keep tracking error down or for investments with that would otherwise have adverse tax consequences. For example, many MLP funds are ETNs because MLP ETFs must legally be C-corporations, which means they must pay taxes on MLP income at the fund level on top of the taxes that will be paid by the MLP ETF owners. The ETN structure avoids this double taxation. Futures-based commodity funds are usually ETNs, partly to minimize index tracking error and partly to convert tax treatment from the 60/40 LT/ST capital gains that applies to futures to potentially 100% long-term capital gain. Inverse and leveraged funds are nearly always ETNs.
According to the Investment Company Institute, the average expense ratio for actively managed equity mutuals funds is .68%, and for active bonds funds, .46%. Costs are much lower for stock and bond index mutual funds, both of which have an average expense ratio of only .06%.
The term “ETF” itself has come to imply an index fund. According to Forbes, 98% of ETFs are index funds that employ passive management tied to an index. As is true for index mutual funds, passive management greatly helps to minimize costs for the issuer—no need to pay for expensive investment staff (portfolio managers and research analysts) or trading costs. On top of that, the ETF structure itself further lowers the costs of operation compared to mutual funds. For example, ETFs do not need to keep track of investor accounts since like stocks ETFs are registered in “street name” and accounting is only done at the broker level—it is up to the brokers to keep track of what their customers own. The broker is also responsible for distributing all required regulatory reports, such as annual and semi-annual reports. Also, since ETF issuers do not buy from or sell to the public directly, there is less need for expensive customer service staff.
The array of underlying indexes is much wider for ETFs than for index mutual funds. According to a recent U.S. News article, at the end of 2021 there were 290 index mutual funds in the U.S. compared to 990 passively-managed U.S. ETFs. If anything, the gap has widened since then. At this point, nearly any investment niche can be accessed through an ETF at a fairly low cost. But the lowest cost ETFs tend to be those that invest broadly, not narrowly. According to the CFA Institute, while the average expense ratio for an ETF is about .50%, that average is driven up by the funds in various specialty categories, such as leveraged, inverse, alternatives, and commodities, all of which tend to be considerably more expensive than average. Most investors focus on low-cost, highly liquid, broadly diversified funds such as these:
Fund Expense Ratio
- Vanguard Total Stock Market ETF (VTI) .03%
- Vanguard Total Bond Market ETF (BND) .03%
- Vanguard FTSE Developed Markets ETF (VEA) .05%
Issue-Specific Risk Diversification
I am continually amazed to find prospective clients who have entrusted their assets to a local broker who picks individual stocks and/or bonds for their account. As I have shown elsewhere, the overwhelming evidence indicates that even the most highly compensated, experienced, and credentialed institutional portfolio managers show no evidence of consistent ability to add value through stock selection, much less your local broker.
Unless you or your broker have an informational advantage relative to other investors, there is no reason to take on the risk of owning individual stocks. The risk you assume in picking GM over Ford, Home Depot over Lowes, or McDonalds over Wendy’s may or may not provide risk-adjusted return over the market, but it is a crap shoot that is certain to add volatility relative to the overall market. And a broker’s research report is far from an “informational advantage!” Financial theory has shown that stock-specific risk is “uncompensated risk” that can (and should) be diversified away by owning the entire market.
Buying an ETF is an ideal way to diversify away issue-specific risk for any asset class or index.
The active return of actively managed funds is next to impossible to predict. Fund managers tend to change their holdings and risk exposures frequently. Even worse is the “style drift” that can happen when a manager decides to deviate from what investors might expect based on the fund's name and/or its historical behavior. How many “value” funds drifted over towards growth over the past ten years in order to avoid severe underperformance? Quite a few, I suspect.
Because nearly all ETFs are passively managed relative to a benchmark index, investors can be confident that they will provide risk and return characteristics that are highly similar to the underlying index. And because most indexes have been published for a very long time, it is possible to do extensive historical analysis of the index in various environments and during various “shock” events to get a sense for how an ETF is likely to perform.
One problem with mutual funds is their lack of intraday liquidity. If you want to sell one mutual fund and redeploy the money in another mutual fund, it is a cumbersome process. The first mutual fund must first be sold. That won’t happen until the end of the day that you decide to sell, at whatever the NAV is at that time. You cannot know what the selling price will be ahead of time. The execution price could be quite different from what it was when you decided to put in the sell order earlier in the day.
On top of that risk, you also have the risk of being uninvested while your selling transaction waits to be settled. In the U.S., that typically takes two days, meaning you will be out of the market for those two days. Then, on the third day, when you put in your order to buy the second mutual fund, again you do not know what the execution price will be—it could be quite different than what you expect.
Even long-term “buy-and-hold” investors will typically need to do some periodic rebalancing back to their long-term strategic targets, and they will face these issues whenever they rebalance. Those investors who do any kind of tactical asset allocation will find that these operational issues loom as a very large impediment to using mutual funds.
Fair Entry and Exit
Because of their structure, mutual funds are not able to treat all of their shareholders fairly. Selling shareholders impose costs on the shareholders who remain invested. When mutual fund investors redeem their shares to the fund, the fund portfolio manager must sell enough securities out of the portfolio to have the cash on hand needed to pay the redemption out in cash. Redemptions that hit the portfolio in the morning are paid out based on the previous evening’s NAV value. The transaction costs paid today to sell the securities needed to meet last night’s redemptions hit today’s closing NAV, and is incurred by the remaining shareholders. The redeeming shareholders do not share in these costs since they are already gone.
ETF redemptions work in a completely different way. When ETF investors want to sell, they do so during the day by selling their shares to a willing buyer at a known price. If the selling pressure becomes too great, the market price of the shares will decline below the NAV. If the discount is large enough, an institutional entity known as an “authorized participant” (often a large broker/dealer or market maker) will step in, buy the cheap shares on the open market, and present them to the ETF issuer to be exchanged for the “redemption basket,” which is usually a slice of the underlying portfolio. (Typically, creation and redemption baskets occur in lots of 50,000 ETF shares each.) Because the redemption is “in kind” rather than in cash, the remaining investors in the ETF are not affected by the transaction. There are no transaction costs. All parties are treated fairly and no one’s actions have an impact on anyone else. This creation and redemption process is what keeps the market price of an ETF very close to its net asset value (NAV).
Index funds have an enormous advantage over actively managed funds when it comes to tax efficiency. The average actively managed U.S. equity mutual fund has a turnover ratio of about 100% per year. That is, the holdings in the fund will be entirely changed over the course of the year on average. That means that a lot of holdings will be sold before they have even been held for a year, so if there are gains, those gains will be short-term capital gains, subject to taxation at ordinary income tax rates. Even if most of the gains are long-term, they will still have to be paid out towards the end of the year in a capital gain distribution, which will hit the shareholders with a tax cost the following April 15. Most actively managed mutual funds have a mix a taxable and tax-deferred investors, and most mutual funds managers are totally fixated on maximizing investment performance and pay absolutely no attention to the tax implications of their trading activity. (I speak as a former mutual manager myself.)
Index funds are completely different. The turnover rate for index mutual funds is typically very close to the turnover rate for the underlying index. These turnover rates tend to be quite low. One analyst estimates that the long-term historical turnover rate of the S&P 500 Index has been 4.4% since 1965. Sometimes companies are merged out of existence and need to be replaced. Sometimes they go bankrupt. However, there is a world of difference between turnover of 4.4% and turnover of 100% in terms of tax implications! The high turnover of actively managed mutual funds tends to get noticed by investors only once a year, in November or December, when mutual fund companies distribute their capital gains to investors, distributions on which those investors must pay a tax.
Even in years when the market is down, many mutual funds have capital gains distributions. Yes, you read that right. Mutual fund investors often have to pay taxes on their shares even during years in which they have lost money!
In stark contrast, ETFs hardly ever have capital gain distributions, even during up market years. How is that possible?
The secret of their enhanced tax efficiency lies in the way ETFs create and redeem shares. When an authorized participant (AP) presents ETF shares to the issuer in exchange for the redemption basket of securities, the ETF is able to decide which tax lots will be delivered in the redemption basket. This provides the ETF manager with the opportunity to deliver out the securities with the lowest tax basis. Because in-kind exchanges with APs happened regularly to both create new shares (in which the AP delivers a “creation basket” in exchange for ETF shares) and redeem existing shares (in which the AP delivers ETF shares in exchange for a “redemption basket”), the ETF manager is able to systematically increase the tax basis in the portfolio. Consequently, even ETFs that are tied to an index with a relatively high level of underlying turnover are usually able to avoid having to make capital gain distributions.
Even compared to a comparable index mutual fund, the tax-efficient structure of an ETF can make a substantial difference in tax costs. Here is an example from a 2015 CFA Institute publication on ETFs:
"An investor in the SSgA (State Street Global Advisors) S&P 500 Index mutual fund (SVSPX), which made regular capital gains distributions, had a compound annual after-tax return of 6.77% in the 10 years ending 30 November 2011. According to Morningstar, an investor in the SPDR S&P 500 ETF (SPY) would instead have avoided paying capital gains taxes along the way and would have paid taxes only on final sale of the shares, thereby earning an after-tax return of 7.12%. That is a difference of 35 bps a year, mostly the result of the tax advantage."
An extra .35% per year. That would cover most of my advisor’s fee!
Summary and Conclusions
- Exchange-traded funds (ETFs) are extremely popular, and for very good reasons: low cost, convenient rebalancing, and tax savings.
- Most ETFs are registered investment companies, the same legal structure as open-end mutual funds.
- Exchange-traded notes (ETNs) are another form of exchange-traded product (ETP) and are unsecured debt securities that do not own any of the securities in the underlying index. Most often, and ETN is issued when the underlying securities are highly illiquid or have undesirable tax treatment.
- 98% of ETFs employ passive management tied to an index.
- This helps to keep their expense ratios low, which is one primary driver of their popularity with investors.
- Index ETFs diversify away stock- and bond-specific risk.
- Because they are tied to indexes, ETFs have known risk and return characteristics.
- Unlike mutual funds, ETFs offer known transaction prices and easy rebalancing trades.
- The actions of other ETF investors do not affect the remaining ETF investors—everyone is treated fairly.
- In-kind redemptions give ETF managers the ability to systematically increase their tax basis and usually avoid making capital gains distributions—unlike mutual funds.
- Even compared to a similar index mutual fund, the tax savings from the ETF structure could be as much as .35% per year.