Exchange Traded Funds (ETFs)
A down in the weeds investing post! Very exciting.
I want to talk about Exchange Traded Funds, commonly known as ETFs. ETFs are fantastical little pieces of financial wizardry, some of the smartest minds on Wall Street spent a long time coming up with them. Anytime someone says that phrase little warning bells should be going off in your head. The smartest minds on Wall Street are generally only interested in one thing – making more money. So if they came up with something fancy you can be pretty certain that fancy thing is helping them do that. ETFs are no different.
I’m not saying that ETFs are bad. They’re not! I own ETF’s in our portfolio. But just like any product sold by massive financial institutions out to make a buck ETFs can be dangerous if used improperly. Don’t use them improperly.
What are ETFs
First, we need a quick discussion of what ETFs are and what they are not. ETFs are essentially just a fancy way of buying mutual funds. ETFs are a bunch of stocks (0r bonds, or other more exotic stuff) mashed up in a nice package. That’s also exactly what a mutual fund is. ETF’s and mutual funds are both just ways of buying a large number of stocks or bonds in one easy package. Just like mutual funds ETFs come in many different flavors. You can find index ETFs that track some of our favorites like the SP500. These funds will simply track the SP500 index, just like a normal SP500 index fund. You can find ETFs that pursue various investment strategies like value or growth investing. ETFs are also offered by most of the same major players in the industry. If you want to take a gander at the full list of ETFs out there be my guest.
So what makes an ETF an ETF? The fundamental difference between an ETF and a mutual fund is simply how they are bought and sold by investors. When you buy a regular mutual fund you send a check or wire money to someplace like Vanguard or Fidelity. They then take that money and put it into their fund’s accounts. The fund administers then your contribution and all the other contributions that come in that day and use them to purchase additional assets for the fund. Reverse this process when you decide to redeem your cash.
ETFs are different. ETFs are represented as shares that are actively traded on stock exchanges. What this means is that you can buy shares of an ETF any time the markets are open through a stockbroker. The ETFs administers never know that someone is buying and selling their ETF. The deal is just between you and some other guy at the other who decided to sell that day. This small change creates a number of very interesting advantages and disadvantage for ETFs.
Advantage 1: Lower Minimums
The minimum purchase amount for an ETF is the price of one share. For the Vanguard SP500 ETF that is about $217 right now. Compare that to the $3000 minimum investment for Investor Shares in the Vanguard SP500 Index Fund. If you only have a little to invest this could be an advantage if it weren’t for some of the disadvantages we’ll talk about later.
Advantage 2: Sell and buy them fast (Liquidity)
Another slight advantage is that you can buy and sell ETFs any time the market is open. Mutual funds can only be bought at sold at the end of every trading day. Since I would never encourage day trading because it is stupid, this is not really much of an advantage. If you’re going to hold something for 10+ years, it doesn’t really matter if you buy it at 11:52 AM or 4:00 PM.
Advantage 3: More tax efficient
This is the largest benefit of ETFs and the primary reason that I recommend using them. When you sell shares in your mutual fund this forces the fund’s administrators to liquidate part of the overall portfolio. The unfortunate thing is that this liquidation can cause realized capital gains for EVERYONE invested in the fund, even if overall their total investment is down. The way mutual funds work is that if the fund sells a position it has made money on it has to distribute those capital gains to all shareholders. This is the capital gains distribution you get at the end of every quarter from your mutual fund. This is bad because you have to pay tax on that distribution. Index funds are generally the best at this since the amount of trading they do is VERY minimal. But ETFs are even better since if someone wants to liquidate an ETF position they just sell it to another guy on the open market without the ETF administrators having to do anything that would affect other holders of the ETF.
Partial Advantage 4: Lower Fees
This is actually the advantage that gets highlighted most often, but this is an advantage that is often deceptive. Because they ETFs often be run more efficiently ETFs often do have lower annual maintenance fees. The Vanguard ETF above has a maintenance fee of 0.05% vs. 0.15% for the fund. This is a great thing! But this is not true for all ETFs. Just like regular mutual funds, there are many ETFs with very high fees as well. The best bet with ETFs is exactly the same as regular mutual funds: low-cost index options.
Additionally, with ETF’s, unlike with mutual funds, those annual fees are not the only fees you pay. We’ll cover that in a second.
Disadvantage 1: You can only buy whole numbers of shares
This is a minor problem, but one headache that can often arise with ETFs is that because they are only sold as individual shares you have to buy whole numbers of shares. This can often make reinvestment of dividends or new contributions difficult. With normal mutual funds, you can usually contribute any dollar value you like. This isn’t a huge issue, but it is there.
Disadvantage 2: Trading Fees
This is the big one. The one that causes all the problems, and the one that should make you be somewhat wary of ETFs. Because ETFs are traded just like any other stock on an exchange, you have to pay your normal brokerage fee. Assuming that you are using a low-cost brokerage this can be around $5-10 per trade. This may not seem like much, but it can wipe out any cost advantage the ETF had. This is one that makes me say BE CAREFUL. If you’re not, you can end up paying more for the exact same product you could get elsewhere.
There are a number of ‘free’ ETFs trade offers out there now from Fidelity to TD Ameritrade. But once again, be careful. These guys are still making money off these programs they’re just doing it in different ways. One of those ways is by offering up ETFs with higher management fees than usual and getting a kickback from the companies running the ETF. This then negates one of the biggest reasons to use an ETF in the first place, low management fees.
The bottom line is that ETF’s can be useful, particularly for tax purposes. If you’re in a higher tax bracket and paying tax on capital gains you should consider them in taxable accounts. And if you pick the right one (low-cost index options are the best choice for ETFs as well!!) and avoid paying trading fees they can be useful investments for everyone. The bottom line is simply to be careful. A free lunch usually isn’t free, but you should know how much you’re actually paying.