Want an inexpensive investment that tracks an index, and you can easily buy and sell during market hours? An exchange-traded fund may fit the bill. Despite being in favor among individual investors and institutions, there are some pitfalls.
Since these investments were unleashed on investors in 1993, their number and variety have exploded. There is an ETF to track just about every market, index, currency, commodity and industrial sector on the planet. According to ETF Trends, “nearly $20 billion per month flowed into ETFs in 2015.”
The reason these things are so wildly popular is they differ from traditional mutual funds in two important ways.
The first is, in general, it costs less to own an ETF than a mutual fund. ETFs have no sales loads or marketing and distribution fees. And, ETFs offer a more tax-efficient investment structure than their open-end cousins. According to Jay Freedman, a tax principal at KPMG, ETFs are structured in a way that defers capital gains until the investment is actually sold. Mutual funds pass gains and income on to investors, who have to pay taxes on those regular distributions.
[See: U.S. News & World Report’s 10 Top-Ranked ETFs.]
So, ETFs offer a couple of distinct advantages over mutual funds. But, don’t be fooled into thinking that there aren’t other costs. After all, there is never a free lunch on Wall Street. Some of the costs of ownership of an ETF are open and straightforward. Others are a bit more opaque. Let’s take a peek.
The most transparent costs of owning an ETF are its management fee and operating expenses. Hey, nobody works for free, right? There are indeed costs associated with having people buy and sell the assets in a fund. Then there are the expenses related to actually running the business. There are real people going into real buildings, sitting at real desks, typing onto real computer keyboards, and talking into real telephones. Each one of those represents real expenses. All of that stuff gets bundled up and fully disclosed in the fund’s prospectus as its expense ratio.
But there are other costs that aren’t quite so obvious.
For example, say you work with a traditional broker who reels in a commission each time he or she shuffles around your portfolio holdings. This type of business model differs from that of a fee-only fiduciary advisor, who has a legal obligation to put your interests first, and isn’t incentivized by earning a cash payment by trading your account. If the kids need shoes or the house needs a new roof, the broker may decide it’s “suitable” to make some trades on your behalf. So, while you may not have considered this when you signed on with a broker, as opposed to a fiduciary, commissions may be an added cost of owning an ETF.
(And if you are currently working with a broker who gets commissions, ask yourself: Why am I paying someone whose interests may be at odds with my own? As the financial-services industry moves toward the fiduciary model, the trading-for-a-commission stock broker is increasingly an anachronism.)
This isn’t likely to be a big deal for the average individual investor. But, if your broker actively trades ETFs, then these transaction costs will have a very big impact on your total return.
But commissions aren’t the only thing that may take a bite out of your trading profits.
Another easily overlooked cost that diminishes an active trader’s total return is the bid/ask spread. This is the difference in price between what a buyer pays for a share of an ETF and what a seller gets when he or she sells that same share.
[See: 7 ETFs for a Solid Portfolio Defense.]
The difference between these two prices is how the market makers or specialists — the people who actually execute the trades — get paid. Remember, nobody on Wall Street works for free. Most investors pay scant attention to the inner workings of the market machine, and are probably not even aware that there is a real cost to each trade. Active traders, however, know they get nicked by the bid/ask spread every time they buy or sell an ETF. For them it can have a real economic impact.
But there is one other cost that is nearly completely invisible to all except the most-focused institutional investors.
All funds — ETFs, mutual funds and closed-end funds — are priced at net asset value. That’s the difference between assets and liabilities, divided by the number of shares outstanding. But its calculation is required to be made only once a day. According to the Securities Exchange Commission, net asset value is typically calculated “after the … exchanges close.”
So, investors (or traders) who buy (or sell) ETFs are likely paying (or receiving) a price that is something other than the actual value of the assets held by the fund.
Here’s how that works: An ETF’s price today isn’t likely to be the NAV that was calculated after yesterday’s market close. And, this not-so-easy-to-see cost of owning an ETF can be significant. In fact, according to professor Antti Petajisto of the NYU Stern School of Business, “prices of exchange-traded funds can deviate significantly from their net asset values.” Petajisto says the range can be as high as 2 percent in some cases. That is a pretty big variance!
For the individual long-term investor, exchange-traded funds are often an efficient way to get broad market exposure. That’s better than buying a bunch of single stocks and trying to create your own “bet.” Because of individual investors’ own biases and knowledge gaps, a homemade allocation is almost always less diversified than a broad portfolio of passively managed funds.
More active traders, those who like to make portfolio changes in response to the news, forecasts or market direction, are likely aware of hidden ETF costs and probably have them factored into their trading regimes.
[See: 9 of the Best High-Yield ETFs on the Market.]
Nevertheless, as with many things on Wall Street, it’s never a bad idea to remain vigilant. Caveat ETF emptor!
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With ETFs, There Is No Free Lunch originally appeared on usnews.com
