What’s not to like about exchange traded funds (ETFs)? These nifty investments trade like stocks, are based on the most popular market indexes around, and sport rock-bottom fees. They can be bought and sold throughout the trading day and are more liquid and more tax efficient than their popular ancestors, the open-end mutual fund.
But not everyone is convinced that ETFs are the way to go. Some cite the commissions that must be paid to buy and sell these instruments. Others are concerned with the bid-ask spread, which adds another layer of trading costs.
Certainly, not all ETFs are created equal. The more esoteric the benchmark, the more problematic it is to trade them. Take the iShares MCSI Malaysia Fund (EWM), which tracks the mostly small-cap MSCI Malaysian stock index. With its 0.59% expense ratio and 0.30% bid-ask spread, this fund will cost 0.89% to own in the first year. After adding commissions (assuming a flat $15 ticket charge on $10,000), the total cost is 1.04%.
But then there’s the premium/discount issue to worry about. Even though ETF shares are traded using specific mechanisms to avoid such spreads, EWM trades at a 0.43% premium to the stocks it actually owns. As a result, the first-year breakeven on a purchase of EWM is 1.47%.
Although that may sound pricey, most open-end funds that specialize in this region are even more expensive. In fact, the EWM would place in the bottom decile of the 82 mutual funds that track the Pacific Rim in terms of total expense ratio. Moreover, since expenses such as commissions and spreads are one-time charges, a long-term investor in EWM is likely to pay less in fees over time than most mutual funds.
Of course, there aren’t that many investors looking to get exposure to Malaysia, but there are scads trying to get access to large-cap U.S. stocks. The table below compares the total expense ratio of a number of large-cap offerings. Since the bid/ask spread and the premium/discount of ETFs vary significantly throughout the trading day, the table is only a rough estimate of such costs.
The table shines several lights on the ETF- versus-mutual-fund conundrum. First off, it’s the one-time charges–the commission, bid/ask spread, and the premium/discount–that can make ETF investing a bit painful in the first year. Long-term in-vestors only have to pay these fees once, which usually makes ETFs a better choice. For dollar-cost-average investors, it’s probably better to go with traditional open-end funds.
Another issue is that of index coverage. There are not many mutual funds based on the Russell indexes, but ETFs abound across both size and valuation spectrums.
Finally, ETFs also have the potential to be much more tax efficient than traditional mutual funds. Since their shares are exchange traded, ETF managers don’t have to worry about raising cash for redemptions. Even when stocks are added or subtracted from an index, ETFs have been able to manage their capital gains.
Our firm was an early adopter of ETFs, and I still think they are the best way to create an indexed portfolio. They are a nifty way to avoid mutual fund trading issues, and their liquidity is a bonus, which appeals to many of our clients. ETFs also do a great job following their benchmarks–in many cases, better than traditional funds.
But don’t take my word for it. With Vanguard and Fidelity poised to launch a slew of ETFs, it seems that even the biggest mutual fund companies are cashing in on the practicality of exchange traded funds.
The Puzzler, CIO of Memphis-based Sovereign Wealth Management, can be reached at firstname.lastname@example.org.