ETFs have become more popular among financial advisors than mutual funds because they cost less, are more tax-efficient and are transparent about their holdings and price throughout the day. In comparison, mutual funds are priced only once daily, after the market closes.
But all these advantages don’t necessarily mean ETFs will perform better than mutual funds. Their performance can be influenced by factors not readily apparent to advisors, according to a new white paper by Pershing and its parent BNY Mellon released this week entitled “What Lies Beneath: Understanding the Structure and Costs in ETFs.”
“Because more assets are going into ETFs we wanted advisors to know the different costs that go into ETF pricing,” says Justin Fay, a vice president for alternative investments and ETFs at Pershing. “ETFs are not always the right choice for a particular strategy.”
These are the four factors that advisors should consider when choosing ETFs for clients, according to the Pershing white paper:
1. Expense ratios. The cost of owning an ETF tends to be lower than the cost of owning a mutual fund simply because trading costs for the ETF’s underlying securities are borne by market makers, not the fund itself as is the case for mutual funds, explains Brian Brennan, VP of global ETF product management at BNY Mellon, in the white paper.
But he warned that expense ratios for complex ETFs such as leveraged and inverse ETFs and master limited partnerships (MLPs) are not necessarily low. The ProShares Ultra Dow30 ETF (DDM), designed to have twice the daily performance of the Dow Jones Industrial Average, for example, has an expense ratio of 95 basis points, which is not untypical for a leveraged long or short index ETF.
“Too many advisors focus on expense ratios and minimize other important factors,” according to the Pershing paper. “Although total expense ratios are important there are other things to consider during a cost-comparison analysis.”