By Maurice Walch
Shakespeare knew what he was talking about. What matters is what something is, not what it is called. Some national columnists and assorted marketing organizations have heralded the introduction of exchange traded funds (ETF’s) as the “cure all” for the small investor to save them from the demon called the “Mutual Fund.” There’s the rub. ETF’s are mutual funds.
Investopedia defines a mutual fund as “an investment vehicle made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments, and similar assets.” That’s exactly what an ETF does. The fundamental difference is that a conventional mutual fund has an active management approach which constantly monitors and rebalances the portfolio — with the objective to outperform their benchmark index. A conventional ETF has a passive management approach that consists of picking a selection of investments the manufacturer feel represents the benchmark index, and not making any changes to it with the objective to perform exactly the same as the benchmark.
So essentially an ETF is a mutual fund with absent management. As you can imagine, there are significant cost savings to not having anyone managing the portfolio. There are no trips to interview the management teams of the companies invested in, no research personnel investigating competitive opportunities, and no regular evaluation to see if a company has either exceeded expectations or under-performed.
Because of this minimal management, ETF’s have two significant advantages. First, in comparison to actively managed mutual funds ETF’s are a low-cost alternative with management fees of an actively managed mutual fund generally being about one per cent more than an ETF. Secondly, in comparison to some individual stocks, ETF’s are highly liquid. As a result, a major user of ETF’s are institutional investors, like pension funds, that want to take a position on a particular market for a limited period of time.
For the small retail investor this liquidity can add an extra cost to investing in ETF’s. The reason being is that when the markets first open or during periods of volatility and institutional investors are selling massive amounts of ETF’s, the underlying stocks in the ETF are consequently put under pressure. This can produce something called “tracking error” which means simply that the price of the ETF is not in line with the value of the benchmark. If the small investor is buying the ETF now, studies have shown that the tracking error is frequently as high as two per cent, and on days of exceptional volatility can exceed five per cent This cost can quickly eliminate any cost savings attained by the reduced management fee.
Another form of tracking error in ETF’s can be seen in some specialty ETF’s such as leveraged ETF’s. Investors sometimes are surprised to see their account values go down while the index actually goes up. The reason being that in something like a triple leveraged ETF for every one dollar the investor has invested, they have three dollars at work. If markets go up, then the investor can theoretically make substantial gains. However, if the market goes down before it goes up, the investor can actually incur a net loss. For example, if you invested $1000 in a triple leveraged ETF and the first day the market was down 15 per cent, you incurred a loss of 45 per cent. Now you only have $550 invested. To get back to your original investment, you need to earn almost 100 per cent on your remaining investment just to get even. These funds are designed for expert investors making a bet on the movement of an index and that are prepared to be invested only for a very short period of time.
ETF’s are passively managed mutual funds can be a very useful addition to a core group of actively managed mutual funds and can help to reduce the overall portfolio management costs. However, proper selection and monitoring must still be done at some level in order for them to be an asset to your portfolio.
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