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This chapter is from the book

Why Invest with ETFs?

Given their many strengths, it is no surprise that ETFs have grown so rapidly. They are ideal for the self-directed investor. Let's take a look at some of the characteristics of ETFs that make them the investment tool of the future, especially compared with mutual funds.

Liquidity and Tradability

Liquidity describes the ease with which an investor can buy and sell an investment. Liquid investments are easy to turn into cash. Homes are not particularly liquid, whereas treasury bills, with a deep market, are highly liquid. Mutual funds lie in the middle. They are only valued once a day, after the market closes, which is the only time they can be bought and sold at net asset value. This can create difficulty for investors. What happens if the market is falling and you want to sell your mutual fund during the day to minimize your losses? You can't. You can only sell it at the end of the day, after the market closes. On the other hand, the market may be starting an upward trend and you want to buy into it with a mutual fund. Forget it. Your order will not go in until after trading has ended, so you will buy the fund after prices have gone up, meaning that you will own fewer shares, for the same amount of money, than if you had been able to make your investment in the morning when the rally started.

One advantage of ETFs compared to mutual funds and many other investment products is their high degree of liquidity. Of course this liquidity may vary between ETFs, but on the whole ETFs are relatively liquid instruments. ETFs trade throughout the day, as does any share of stock, making it easier to get in and out of an ETF compared to a mutual fund. Of course, the buyer or seller is not guaranteed of making the sale at a desired price, but the flexibility can benefit the investor. That flexibility extends to the types of orders investors can use to buy and sell ETFs, which are the same as for stocks, including limit, market, and stop loss orders. These orders cannot be used with mutual funds. In addition, traders can sell an ETF short, which cannot be done with a mutual fund, to profit from a falling market. Also, investors can buy ETFs on margin, meaning they can lever their funds to command a larger portfolio, but at the same time face greater risk from an adverse market move.11

Transparency

As Bernard Madoff's investors found out the hard way, investors need to know what is in their portfolios. Not knowing what is in one of their funds could lead to people owning something twice—once, for example, as a single stock and again within a mutual fund, which could mean overweighting in particular stocks or sectors. With opaque investments, such as hedge funds, it is highly unlikely investors will know the portfolio's contents, given the secretive nature of hedge fund managers. Even mutual funds are somewhat opaque. A fund may have a mandate to invest in a particular area, but managers are only required to disclose their portfolio every six months, and that information has 60 days to get to investors, so by the time investors receive notification of the fund's holdings, the fund could have turned the portfolio over, adding a totally different group of stocks to the portfolio and making it hard to know what the fund holds at any given time.

ETF owners do not have this problem, because an ETF's components are required to be disclosed, along with their stock prices, every 15 minutes throughout the trading day. An ETF owner, by accessing a website or contacting her broker, can always know what makes up the ETF and what weights are given to each underlying security.

Diversification

Investing all of your resources into a single stock means that if the company goes out of business, you lose all your money. While that is an extreme case, it shows the need to diversify investments, especially when investing in risky fields such as biotech. Investing in a number of companies reduces the risk from putting everything in a single stock, while also damping potential returns. That is the tradeoff between risk and return. What is needed is a way to invest in an industry, yet not have all your money tied to one company. ETFs provide that way to invest, as they enable you to concentrate in a sector, cheaply, yet still have diversification among different companies.12

It is important for investors to understand that diversification needs to be considered in the context of the investor's plans and life cycle. An investor needs to concentrate (in a certain investment area) to get rich and diversify to stay rich. When you are seeking to build wealth, that is the time to concentrate. When you are seeking to preserve wealth, that is the time to diversify. Preservation through diversification comes down to taking fewer risks and having investments over a wider field—accepting the tradeoff of potential lower returns for the accompanying lower risk. To concentrate in an investment area, we believe in applying concentrated diversification—choosing to invest in an area, such as biotech, but diversify by investing in a basket of securities in that area, as opposed to pinning your hopes on one or two companies. The natural tool for concentrated diversification is the ETF, allowing investors to access depth and breadth across numerous industries.

ETFs allow investors to put their money into a sector that they believe has the potential for good performance without having the worries of betting on a single stock—the ETF provides a diverse range of companies in that sector. Yes, some may fail, but it is likely that the majority will stick around. Say you want to invest some of your money in biotech, because you believe it can produce significant returns in the future, and you have $10,000 to do so. You decide to put all of that $10,000 into one company, Genepool Biotechnology (a fictional company), that has one drug in FDA trials. After your investment, the drug fails to show any results in treating the intended disease, and the company goes out of business—along with your money and your bet on healthcare. On the other hand, had you put the money into the Better Health Biotech ETF (also fictional), which had 20 companies, 5 of them may have failed, but 15 continued, giving you a way to invest in a sector, without having to worry about the financial health of each individual company. In biotech, where the success of companies depends on the outcomes of drug tests that no one can predict (even biotech experts have trouble picking potential winners from losers), baskets are a sensible way to buy into an industry. True, you may be better off picking the biotech winners, but how many of us can do that, given the uncertainty of drug trials? ETFs allow you to buy an industry in one shot, without your chance riding only on one company.

Tax Efficiency

ETFs are tax efficient investments. ETFs reduce or eliminate tax burdens associated with actively managed mutual funds.

The first is taxation due to portfolio turnover. Mutual fund managers can easily turn over a fund's entire portfolio in a year—or less. This frequent, often short-term trading means capital gains taxes—and often the more onerous short-term capital gains taxes. An investor can buy a mutual fund, hold it, and wind up with a large tax bill, even though she hasn't sold her shares. To a lesser extent, this can also affect index mutual funds. Whenever an index is adjusted, the fund needs to sell those stocks that are going out of the index and buy those that are coming in, which often means that fund shareholders need to pay capital gains taxes, even if they don't sell their funds. This rarely happens with ETFs because the creation and redemption system minimizes tax liabilities.

If shareholders decide to redeem their shares and the mutual fund does not have enough cash on hand to pay them, then the fund sells shares to raise the cash, yet the remaining shareholders have to foot the tax bill if there are any capital gains. So, once again, mutual fund shareholders wind up paying taxes when they have simply held onto their investments and taken no action of their own to incur taxes. Even index mutual funds have this problem. ETF holders do not have this problem because when other ETF investors sell their shares, they sell to another investor, not the fund company. The only capital gain is incurred by the investor who sells their shares—not the investor who holds onto their shares. This is another reason to consider ETFs, as they give investors more control over when they incur taxes as opposed to getting a tax bill because of the actions of others.

Low Cost

Not only do ETFs save investors money on taxes compared to mutual funds, their low-cost structure may also help them outperform mutual funds. Since ETFs simply track the performance of a particular index, don't need to make investment decisions, and don't have major infrastructure, they do not have the high management and administrative costs of a mutual fund.

Choosing an ETF because it is the cheaper way to invest is a natural outgrowth of everyday consumer behavior. When people shop, they compare based on price and quality. Consider two bakeries that sell the exact same bread—same ingredients, same baking process, and so on. La Panaderia is a small, family-owned bakery with low overhead because it does not advertise and keeps expenses down. Ye Olde Bread Shoppe is part of a national chain that advertises heavily and has a fancy store in addition to having its employees dress in medieval English costumes, which adds to costs. The two bakeries are located on the same block, equidistant from shopper Jane's house, and they have the same business hours (see Figure 1.4). However, there is a difference: La Panaderia sells wheat bread for $1.00 per loaf, and Ye Olde Bread Shoppe sells the exact same bread for $2.00 per loaf. Jane, after making a comparison and deciding she does not need to buy bread from people dressed up like Maid Marian or Robin Hood, goes to La Panaderia because her money goes further at La Panaderia.

Figure 1.4

Figure 1.4 Same bread, different price

If we can comparison shop and save money when buying bread, why not do the same when buying investment products? After all, that's what we do when we invest; we buy a vehicle that we hope will perform well at the lowest possible entry cost. Now that Jane has bought her weekly bread supply, and saved money by going to La Panaderia, she now wants to invest some of those savings. Jane wants to invest in healthcare. She looks at both a mutual fund and an exchange traded fund. The mutual fund is the Morgan Stanley Health Sciences B (HCRBX), and the other is the iShares Dow Jones U.S. Pharmaceuticals Index Fund (IHE). Table 1.3 shows the top ten constituents of each list. There are a lot of commonalities.

Table 1.3. Top Ten Constituents of Morgan Stanley Health Sciences B (HCRBX) and iShares Dow Jones U.S. Pharmaceuticals Index Fund (IHE)

Morgan Stanley Health Sciences B (HCRBX)

iShares Dow Jones U.S. Pharmaceuticals Index Fund (IHE)

Security

% of Fund

Security

% of Fund

Johnson & Johnson

10.82

Johnson & Johnson

8.69

Pfizer

10.07

Pfizer

9.88

Abbott Labs

4.75

Abbott Labs

7.39

Bristol-Myers Squibb

4.50

Bristol-Myers Squibb

6.09

Merck

4.38

Merck

10.09

Eli Lilly

3.17

Eli Lilly

5.53

Wyeth

5.06

Allergan

4.44

Gilead Sciences

4.48

Hospira

3.66

Medtronic

3.34

Forest Labs

3.41

Schering Plough

4.02

Mylan

3.21

Examine their contents—really they are not that different; their top ten lists share six companies, although the mutual fund is much more heavily weighted to the top two companies—Johnson & Johnson and Pfizer. So, as with the bread, buyers are getting the same goods. Where the difference lies is in the costs, seen in Table 1.4. The mutual fund is five times the price—for inferior returns.

When dealing with two similar investments, lower costs usually make the ETF the better performer for investors looking for diversified instruments.

It's highly unlikely that a mutual fund will beat the index—once costs are factored in, that probability falls even closer to 0. The low-cost investment is the safer wager. The main reason the ETF costs less is because the mutual fund investor pays for a lot of infrastructure. Those costs add up, while the ETF investor only pays a brokerage fee and a modest management fee.

ETF investors avoid all these fees that reduce returns for mutual fund shareowners:

  • Front end loads of up to 8.75% when they buy a fund
  • 12b-1 fees, whereby an investor pays for the manager to recruit new investors to the fund
  • Shareholder service fees to pay for the investors' support infrastructure of the fund
  • Account fees for small accounts
  • Management fees that can easily be ten times as much as an ETF's management fee
  • Sales charges when they sell their funds
  • Redemption fees of up to 2% to sell their shares back to the fund

Consider the investors in the funds listed in Table 1.3, assuming a 6% per year return.

The investor in IHE will receive a return of 5.52% per year (6% – .48%), while the investor in HCRBX will receive a return of 3.6%, as seen in Table 1.4. Over 25 years, the investor in the low-cost fund has over 50% more than the investor in the high-cost fund before taxes.

Table 1.4. Comparative Fund Data

Fund

HCRBX

IHE

Expense Ratio

2.40%

0.48%

1 Year Return

33.27%

51.41%

3 Year Annualized Return

-0.24%

2.71%

Standard Deviation

17.2

17.98

Sharpe Ratio

-.10

-.05

Annual Rate of Return after expenses assuming 6% return for market

3.6%

5.52%

Return after 25 years on initial investment of $10,000 with reinvestment of returns

$24,210

$35,514

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