Exchange Traded Funds – Pros and Cons

Exchange Traded Funds are created to gain broad market exposure, like mutual funds, that individual investors could not have achieved on their own.  But built upon mutual funds, exchange traded funds actually combine different features of different types of mutual funds to make them available all in one single ETF, namely the valuation feature of open-end mutual funds and the tradability feature of closed-end funds.

Trading and Pricing of Exchange Traded Funds

As we know, shares of ETFs can be traded on exchanges, just as closed-end funds are also exchange-traded, whereas shares of open-end mutual funds can be bought and redeemed only at the end of the day through fund companies.  On the other hand, thanks to the arbitrage mechanism that all ETFs have and similar to open-end mutual fund valuation, the value of an ETF as traded stays very close to the net asset value of the underlying securities in the ETF, with a spread of around 1% if any.  Market prices of closed-end funds could sometimes trade at a 10% or more premium or discount to their net asset value depending on market conditions.  Thus, ETFs provide both the pricing stability and the trading convenience in one single product.

Cost Comparison Between ETF’s and Mutual Funds

Three types of costs can be borne by investors of a typical mutual funds: fund expense, transaction fees, and loads (sales commissions charged by brokers).  But for ETFs, since investors buy and sell shares all through trading with each other, there are no transaction fees and loads of any kind, front end or back end.  The only cost is the operation expense charged by the ETF.  Expense ratios of ETFs are much lower, often in the range of 0.1% to 1%, comparing to mutual funds’ 1% to 3% or more.  One big reason for the lower expense ratio is that ETFs do not need to constantly buy and sell securities to accommodate shareholder purchases and redemptions.  Another reason is that most ETFs are index funds and not actively managed (generally), reducing costs substantially.

Tax Efficiency of Exchange Traded Funds

The more investment turnovers, the less tax efficiency from having to pay capital-gain tax on all sales.  The reasons why ETFs are low cost also provide the ground for their tax efficiency, that is, ETFs acquire and dispose of underlying securities only through in-kind exchange with authorized market makers on the initial market level in so-called creation units, i.e. ETF shares as issued.  Investors pay capital-gain tax, if any, only when they sell ETF shares they own on the secondary market themselves.  In the case of mutual funds, all investors must bear the tax when the fund has to sell securities just to meet the redemptions of certain shareholders.  And most mutual funds, except index mutual funds, are actively managed, potentially generating more capital gains and thus more taxes on them.

Commissions and Exchange Traded Funds

In addition to expense costs charged by ETFs, investors do incur regular brokerage trading commissions every time they buy and sell ETF shares, just like trading stocks.  Mutual fund shares obtained directly from fund companies involve no commissions.  But again, share redemptions almost always have transaction fees.  (Using a company such as TradeKing, Zecco, or Sharebuilder can help keep commissions low.)

Index ETFs vs. Actively Managed ETFs

One reason why mutual funds are still in need to many investors is that most of the mutual funds are professionally and actively managed, whereas many ETFs are index funds.  There will be always investors who believe in picking stocks in order to beat the market and that’s one thing ETFs can not provide.  For now, actively managed ETFs are still rare, with the first one offered only in March 2008.

Who Should Invest in ETFs

Investors who look for broad exposures to different markets, trade more frequently but don’t want to handle huge price swings, don’t have either the time or the required expertise to pick winners and losers, and are not willing to pay too much for the benefits of an investment product, should find ETFs a very good fit.

Do you invest in exchange traded funds (ETF’s)?  What do you think of them?