From the November 2015 issue of Investment Advisor • Subscribe!

ETFs Are Not Just for Trading

ETFs can be just as useful as mutual funds in buy-and-hold strategies

Did you know? You can earn continuing education credits by answering questions about this article.

Start earning credits
Don't rule out ETFs as good buy-and-hold strategies. Don't rule out ETFs as good buy-and-hold strategies.

Over time, I have read many articles that aim to educate advisors on the best practices of using an ETF versus a mutual fund. Among the biggest considerations of such a decision is if an advisor plans to “trade.” Such stories typically indicate that a mutual fund would be the better choice if the advisor plans to simply buy and hold. The premise behind that notion is that if an advisor will not regularly trade the position, why buy a structure with an unneeded feature and avoid the additional costs — specifically, spreads and commissions — associated with making the initial investment in an ETF.

What this line of thinking ignores is the inherent operational and tax efficiencies that are built into the ETF structure. It can be easy to underestimate this benefit for two reasons. First, it is difficult to have a true apples-to-apples comparison in the ETF and mutual fund structure. One will not likely find an ETF and a mutual fund that are managed the exact same way and have the exact same inflows and outflows. Second, the operational and tax savings and resulting positive impact on performance returns in the ETF structure are not identified by a line item in the fee table of an ETF prospectus.

Nonetheless, overlooking the significant operational and tax benefits of the ETF structure, or not understanding their potential impact, could cause someone to quickly dismiss an ETF investment as being a good buy-and-hold investment. Thankfully, real data can provide a good estimate of the actual difference.

As an example, the Invesco Equal Weight S&P 500 mutual fund carries nearly an identical investment strategy offered by a Guggenheim ETF. Despite these similarities, the table below provides a closer look at the tax-adjusted returns provided by Morningstar (as of Sept. 30, 2015).

Comparing ETFs and Mutual Funds (Source: Morningstar)

There are a few key items to point out. First, these two strategies are close but not exactly the same, as evidenced by the pre-tax performance numbers. For any buy-and-hold investor of the ETF, the dividend distributions of this equity strategy caused the after-tax performance returns to be less. Factoring in the cost of the trade, the closing price for the ETF on Sept. 30, 2005 was $162.77 — so assuming a .05 spread and $15.00 commission on a $10,000 transaction, there would be $18.07 of exchange-traded costs. This would add 18 basis points of cost. Based on the average annualized difference of after-tax returns, this cost would have been recovered by the performance differential in the first year. For the next nine years, the buy-and-hold ETF investors would then have witnessed demonstrably better returns.

To be clear, this comparison has nothing to do with Invesco and its capabilities. It is an outstanding investment management firm. It is merely to illustrate structural differences between a mutual fund and an ETF, and to displace any preconceived notion that the latter is for trading when that is not the case at all.

Mutual funds still hold the lion's share of the industry's assets under management. Most ETF assets are still in asset classes such as domestic equity and international, as well as sectors. There are not a lot of ETF assets in balanced strategies, asset allocation strategies or actively managed strategies.

As more advisors gain a thorough understanding of the costs and benefits of the ETF structure and realize that it is just as useful a buy-and-hold vehicle as it is a trading vehicle, a dramatic shift should continue to occur with more growth in the ETF space. More importantly, this ongoing growth will occur in the ETF strategies that advisors utilize for their clients.

Reprints Discuss this story
We welcome your thoughts. Please allow time for your contribution to be approved and posted. Thank you.

Related

ETFs: 4 Things Advisors Should Know Before Buying

ETF performance can be influenced by factors not readily apparent to advisors, according to a Pershing paper.

Most Recent Videos

Video Library ››