Exchange traded funds grow in popularity

Exchange traded funds have grown from $100 billion in 2002 to $1.7 trillion by the end of 2013.

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ETFs are similar to mutual funds – both ETFs and mutual funds can be thought of as a “basket” of stocks and other assets combined into a single product. The advantage of both ETFs and mutual funds, over purchasing an individual stock, is that the investor is purchasing a diverse collection of assets. The conventional wisdom is that diversification reduces risk since you have not “put all of your eggs in one basket.”

But ETFs differ from mutual funds in several ways. First, the vast majority of ETFs are not actively managed so the fees and costs of ETFs are much lower than actively-managed mutual funds. This is one of the selling points for ETFs when compared to actively-managed mutual funds.

Low-cost index mutual funds are probably the type of mutual fund most like ETFs in this respect. A basic question, though, is whether lack of management as such is good or bad. Some say index funds will equal or outperform most professionals actively managing a mutual fund, so the thinking is why pay managers fees to try to outguess the market when most of the time they cannot?

Another difference between ETFs and mutual funds is that ETFs can be bought and sold throughout the day, whereas mutual funds are priced once a day at the market close.

The individual investor’s ability to buy and sell ETFs on the market may be an advantage, a disadvantage, or irrelevant to investors not inclined to buy and sell. Warren Buffet, when asked to compare ETFs and index funds in 2007, recommended index fund fees with low fees for the average investor because average investors don’t have time to do the research necessary to make clever short-term speculative investment moves. Many academic studies show that individual investors may be better off just accumulating rather than trying to gain an advantage through frequent trading.

However, informed investors who are so inclined can buy and sell ETF shares in response to shifts in market value, buy on margin, sell short, etc., which are not possibilities with mutual funds.

With buying and selling come brokerage fees. Some brokers offer no-fee ETF trading for certain ETFs. Another potential buy-sell advantage to ETFs is that it may be easier to buy very small quantities than might be the case for certain mutual funds. If you are getting into ETFs with plans to buy and sell frequently, rather than buy and hold, balance the impact of brokerage fees against the likely profits you think that your trading decisions will generate.

Another selling point for ETFs is that they are more “tax-efficient” than mutual funds. This is generally true and has to do with the structure of ETFs, which is different than mutual funds.

However, the bottom line is that ETFs held in taxable accounts (rather than a tax-sheltered account, like a 401(k)) will, in most cases, generate fewer tax liabilities in the course of management of the fund than will mutual funds holding the same types of investments. This is because when mutual fund managers re-balance and re-allocate, they must actually sell securities, resulting in capital gains.

These gains are passed through to shareholders even though the shareholders have not sold their mutual fund shares. Everyone who owns mutual funds has had the experience of reporting taxable income from funds even though the taxpayer personally has not sold from the fund that generated the tax.

But because of the structure of ETFs, ETF managers usually can manage inflows and outflows in ways that do not result in passing through capital gains to ETF investors.

But there are exceptions. Certain types of ETFs, such as leveraged/inverse ETFs, may have significant capital gain distributions. Regardless, when investors sell an ETF, that sale is subject to capital gains tax just as sale of stock would be.

ETFs continue to grow in popularity. The advantages and disadvantages should be weighed in relation to the individual investor’s preferences and goals when deciding whether and to what extent to include them in a portfolio. – Mike Wilson, J.D.