How many times have you heard or read it? Exchange-traded funds are overtaking traditional mutual funds in both popularity and asset growth. Regardless of whether you’re tired of hearing or reading it, this is a dynamic shift in the nature of the investment management business that financial professionals should not ignore.
According to a just released research report from Financial Research Corp. (FRC), an amazing 71 percent of financial professionals used ETFs in 2008, up from just 25 percent in 2003.
Let’s examine four key reasons why ETFs are gaining ground on traditional mutual funds.
Even though the Securities and Exchange Commission has the noble goal of forcing Wall Street to provide investors with full disclosure, it often misses the mark. A lack of financial transparency contributed to the financial meltdown in certain securities, like credit default swaps along with unregistered hedge funds. Even today, it’s difficult to assess the true level of risk taken by market participants if nobody knows who owns what.
What about mutual funds? Funds disclose their portfolio holdings during the first and third quarter using form N-Q and during the second and fourth quarter via the semi-annual and annual report. All holding disclosures are reported with a 60-day lag. Regarding mutual fund holdings, the Schwab Center for Financial Research states, “Frequently, you may not know which securities you’re exposed to in the fund or what changes a manager has made until you get the semiannual report.”
By contrast, with index ETFs there is always 100 percent transparency about what securities the funds own and holdings can be viewed daily at provider websites.
Critics of ETFs have tried to demonize their intraday liquidity feature. One argument is that ETFs encourage investors to become day traders. If that’s true, what can be said of other exchange-traded securities like stocks and closed-end mutual funds? Shall we take the massive trading volume of Microsoft (MSFT) or Exxon Mobil (XOM) and wrongly conclude that all of the buyers and sellers are short-term traders?
Morningstar recently launched a helpful tool that illustrates the cost of ETF bid/ask spreads in percentage terms. However helpful this new tool is, it’s wrong to conclude the cost of bid/ask spreads is exclusive to ETFs.
Other exchange-listed securities, like stocks and closed-end funds have a bid/ask spread cost attached to them too. Also, mutual funds that own stocks are impacted by this subtle cost — a real cost not reflected in a fund’s expense ratio. Wouldn’t it be neat if Morningstar could start publishing the full spectrum of mutual fund costs by including bid/ask spread data for the underlying securities on all the mutual funds in its database? It’s already done this for ETFs. Why not stocks and mutual funds?