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Exchange-Traded Funds (ETFs): Now Individuals Can Invest Like the Big Players

Nov 3, 2008

📄 Contents

␡

ETFs Are a Special Type of Mutual Fund
ETFs Avoid the Expense of Fund Managers
ETFs Are Traded on Exchanges
ETF Investors Have Hidden Costs Through the Bid-Ask Spread
The Creation/Redemption Process Keeps ETF Share Prices Close to the Market Value of the Underlying Shares
ETF Performance Is Not Weighed Down by Transaction Costs
ETF Shares Are Often More Tax-Efficient Than Mutual Funds
Special Risks of ETFs
Conclusion

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ETF Investors Have Hidden Costs Through the Bid-Ask Spread

From the earlier discussion, you can infer that the price you pay for your ETF depends on the balance of supply and demand for that ETF at the time your order hits the trading floor. An ETF's share price is usually slightly different from the market value of the fund's underlying holdings. Moreover, the price a buyer pays is generally higher than the price a seller receives.

Selling a used car is a useful analogy. If you know how much you want for your car, you can sell it yourself. If a willing buyer sees your advertisement, he may take the car off your hands at a price you both feel is fair. However, you might not be able to locate a buyer.

If that is the case, you might decide to sell your car to a dealer. The dealer then pays a price low enough for him to expect to turn a profit when he resells your car. The dealer's knowledge of the car's value comes from observing the used-car market. Ideally (for the dealer), he would like to offer you as little as possible, but if the offer is too low for your liking, you will simply look for another dealer. On the other hand, if your demands are too high to leave room to profit, the dealer will let you walk.

If you accept the dealer's offer on your car, he will try to resell it at a higher price. Suppose the dealer is extremely lucky—the second after you leave the lot, a buyer enters, looking for exactly the car you just sold. Naturally, the dealer will sell it at a profit. The same car on the same day was worth less to you, the seller, than it was to the buyer.

Trading ETFs on exchanges works much the same way. If you as an ETF buyer are offering the same price that a different seller is demanding, the stock exchange is supposed to match up the two of you so that each of your orders can be filled. (However, exchanges have not always functioned this way, giving rise to periodic scandals and investigations. As a result, you should pay attention to the quality of your trade execution.)

However, suppose you want to buy an ETF at a time when a willing seller is not around. In that case, a dealer or specialist in a stock exchange offers to fill your order. Just as with a car dealer, a stock dealer transacts with you only at a price that allows him to make a profit. With the advent of electronic trading, you (through your broker) can look for the best price available for the ETF you want on more than one exchange. This is analogous to shopping around for the best price at multiple car dealerships.

If the dealer sells you the shares you want, he immediately tries to repurchase them from someone else at a lower price. If you turn around and try to resell your shares to a dealer (or specialist, or market maker), you receive less than you paid, even if the market has not moved one iota in the interim.

The price you pay to buy shares at the lowest available price is called the asking price, or ask. The price you receive when you sell shares at the highest available price is the bid. As with cars, stock dealers stand ready at any time to sell you shares at the ask price or to buy shares from you at the bid price.

The difference between the price you have to pay to buy shares and what a seller would receive to sell shares is called the bid-ask spread. The bid-ask spread is no less a cost to you than a broker's commission, despite being less visible (see Table 1.1). But to the unwary investor, the bid-ask spread is a hidden cost. Before you decide to buy an ETF, you should ask your broker for both the bid and ask so that you can get a feel for the cost per trade.

Table 1.1. Bid-Ask Spreads as a Percentage of the Share Price for Selected U.S. Equity ETFs During Normal Midday Market Conditions in the Fall of 2005^*

ETF Name	ETF Ticker Symbol	Investment Objective	Bid Price ($)	Ask Price ($)	Bid-Ask Spread as % of Midpoint	Size of Market (Shares in 100s, BidxAsk)
S&P 500 Depository Receipts	SPY	Large cap	123.81	123.83	.02%	750x400
iShares Russell 100 Index Fund	IWB	Large cap	67.08	67.16	.12%	100x132
Vanguard Large Cap ETF	VV	Large cap	54.77	54.84	.13%	500x600
Diamonds Trust	DIA	Large cap	107.06	107.08	.02%	600x300
iShares Russell 1000 Growth Index Fund	IWF	Large growth	50.62	50.69	.14%	100x600
iShares S&P 500 Growth Index Fund	IVW	Large growth	58.71	58.81	.17%	600x900
Vanguard Growth ETF	VUG	Large growth	53.06	53.11	.09%	300x379
iShares Russell 1000 Value Index Fund	IWD	Large value	68.40	68.49	.13%	600x620
iShares S&P 500 Value Index Fund	IVE	Large value	64.40	64.51	.17%	300x600
Vanguard Value ETF	VTV	Large value	56.39	56.44	.09%	491x94
iShares S&P 400 Midcap Index Fund	IJH	Midcap	72.12	72.16	.06%	30x30
S&P Midcap SPDR	MDY	Midcap	131.46	131.49	.02%	300x125
Vanguard Extended Market Index ETF	VXF	Midcap	89.13	89.25	.13%	600x600
iShares Russell Midcap Index Fund	IWR	Midcap	85.83	85.91	.09%	490x1000
iShares Russell Midcap Growth Index Fund	IWP	Midcap growth	90.99	91.10	.12%	300x900
iShares S&P 400 Midcap Growth Index Fund	IJK	Midcap growth	73.33	73.43	.14%	300x300
iShares Russell Midcap Value Index Fund	IWS	Midcap value	122.22	122.28	.05%	10x74
iShares S&P 400 Midcap Value Index Fund	IJJ	Midcap value	69.34	69.45	.16%	300x300
iShares S&P 600 Index Fund	IJR	Small cap	57.42	57.47	.09%	50x50
iShares Russell 2000 Index Fund	IWM	Small cap	66.21	66.22	.02%	500x32
iShares Russell Microcap Index Fund	IWC	Small cap	50.51	50.59	.16%	200x300
Vanguard Small Cap ETF	VB	Small cap	58.93	59.02	.15%	300x300
Vanguard Small Cap Growth ETF	VBK	Small cap growth	56.99	57.15	.28%	500x500
StreetTracks Small Cap Growth	DSG	Small cap growth	79.71	79.87	.20%	50x50
iShares S&P 600 Small Cap Growth	IJT	Small cap growth	114.60	114.70	.09%	3x25
iShares Russell 2000 Growth	IWO	Small cap growth	68.55	68.59	.06%	130x60
Vanguard Small Cap Value ETF	VBR	Small cap value	61	61.11	.18%	900x600
StreetTracks Small Cap Value	DSV	Small cap value	62.01	62.17	.26%	50x100
iShares S&P 600 Small Cap Value	IJS	Small cap value	63.89	63.98	.14%	300x300
iShares Russell 2000 Value	IWN	Small cap value	65.88	65.92	.06%	95x40
Select Energy Sector SPDR	XLE	Sector energy	47.6	47.65	.10%	200x315
iShares Dow Jones U.S. Financial Index Fund	IYF	Sector financial	100.77	100.91	.14%	300x900
iShares Dow Jones U.S. Financial Services Index Fund	IYG	Sector financial	113.54	113.68	.12%	300x900
Select Financial Sector SPDR	XLF	Sector financial	31.58	31.59	.03%	600x1000
Vanguard Financial ETF	VFH	Sector financial	55.78	55.87	.16%	300x300
Vanguard Health Care ETF	VHT	Sector health care	53.07	53.16	.17%	300x600
Select Health Care Sector SPDR	XLV	Sector health care	30.96	30.98	.06%	900x100
iShares Dow Jones U.S. Healthcare Index Fund	IYH	Sector health care	61.76	61.85	.15%	300x600
iShares Cohen & Steers Realty Majors Fund	ICF	Sector REITs	73.28	73.37	.12%	110x120
iShares Dow Jones U.S. Real Estate Index Fund	IYR	Sector REITs	64	64.02	.03%	56x130
Vanguard REIT ETF	VNQ	Sector REITs	59.79	60.04	.42%	100x100
iShares Dow Jones U.S. Technology Index Fund	IYW	Sector technology	49.55	49.62	.14%	900x100
Select Technology Sector SPDR	XLK	Sector technology	21.10	21.12	.09%	330x1400
iShares Goldman Sachs Technology Index Fund	IGM	Sector technology	46.97	47.04	.15%	101x230
Vanguard Information Technology ETF	VGT	Sector technology	48.03	48.12	.19%	600x600
Utilities HOLDRs	UTH	Sector utilities	109.22	109.30	.07%	100x65
Select Utilities Sector SPDR	XLU	Sector utilities	30.45	30.48	.10%	1200x800
Vanguard Utilities ETF	VPU	Sector utilities	63.34	63.46	.19%	900x600
iShares Russell 3000 Index Fund	IWV	Total market	74.32	74.42	.13%	100x100
iShares Dow Jones Total Market Index Fund	IYY	Total market	62.51	62.59	.13%	100x100
Vanguard Total Market ETF	VTI	Total market	121.95	122.07	.10%	100x900
iShares Lehman Aggregate Bond Index Fund	AGG	Bond	99.39	99.79	.40%	300x350
iShares Lehman 7-10 Year Treasury Note Fund	IEF	Bond	82.47	82.55	.10%	350x1000
iShares Lehman TIPS Fund	TIP	Bond	102.26	102.46	.20%	400x400
iShares Goldman Sachs Investop Corp Bond Fund	LQD	Bond	106.09	106.76	.63%	300x250
iShares Lehman 20-Year Treasury Bond Fund	TLT	Bond	88.72	88.82	.11%	2500x2500
iShares 1–3 Year Treasury Note Fund	SHY	Bond	80.08	80.13	.06%	1000x1000

Bid-ask spreads and brokers' commissions are disadvantages of ETFs compared to regular mutual funds, which you can purchase without incurring either expense. However, mutual fund investors also bear these costs, albeit in a less visible way.

If the mutual fund must make transactions as a result of share purchases or redemptions from any shareholder or on the basis of investment decisions that the portfolio manager makes, the fund bears the costs of a bid-ask spread in addition to the brokerage commissions for whatever stocks it trades. These expenses of the fund are not reported as part of its expense ratio. The typical equity mutual fund turns over 100 percent of its portfolio each year.

Because ETFs are passively managed, the underlying stock portfolios turn over slowly compared to most mutual funds. Therefore, ETF performance is far less impaired by transactions in the underlying stocks than is the case with most mutual funds. (This advantage somewhat offsets the burden that an ETF investor has of paying for his own transaction costs.) The extent to which mutual funds suffer from transaction costs in their stock portfolios varies widely, depending on the manager's investment style, the type of stocks in which the fund invests, and the level of shareholder additions and redemptions. Information about how much a regular mutual fund spends on brokerage commissions and adverse market impact is difficult to uncover and is not included in the mutual fund's expense ratio.

As you might expect, dealers respond to changes in the balance between supply and demand. If everyone wants to sell at the same time but no one wants to buy, the price falls. That is to say, the bid price drops. Again, all this is independent of the actual market value of the underlying stocks that the ETF holds.

The question then arises, what is to stop ETFs from trading well above or below the market value of the underlying stocks? The next section discusses the unique feature of ETFs that keeps them in line with fair market values.

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