Second of a two-part series
In our first piece on exchange-traded funds (“What’s an ETF? And Why Isn’t It a Mutual Fund?”) — based on Bowen Asset Management’s visit to the “Inside ETFs” conference in Hollywood, Fla., in February — we looked at basic definitions of ETFs and contrasted them with the more widely understood mutual funds. In this second part, also drawing on our experiences at the four-day gathering that Bloomberg called “the marquee event for exchange-traded funds,” we will delve into the nuts and bolts of how ETFs work for investors and how they can be as actively managed as mutual funds.
As stated in our first piece on ETFs, there are fundamental differences between ETFs and mutual funds, which are not always adequately understood by investors. These differences can impact both the investment process and portfolio returns. Among the issues related to these differences are diversification (by both portfolio and sector), pricing and liquidity, fees, minimum investment thresholds, and tax treatment.
Everything begins with the prospectus for both mutual funds and ETFs: information for investors mandated by the Investment Company Act of 1940, which is one of the key pieces of legislation supporting the U.S. financial regulatory process. The prospectus lays out clearly how the funds are structured and how they invest their underlying assets. Every prospectus outlines the investment limitations of each of the funds. These documents provide the subtle nuances of the funds and are required to be filed with the Securities and Exchange Commission. Each prospectus provides the date of issue, minimum investments, investment objectives, investment strategies, risk factors, performance data, fees and expenses, tax information, and investor services.
Diversification
Diversification, offered by both ETFs and mutual funds, provides less risk to investors. But while there is a broad array of mutual fund products, ETFs may serve as better vehicles for portfolio diversification. Despite there being many industry-specific mutual funds, there is an offering of highly focused ETF products that offer the ability to invest in sub-sectors of an industry as well as investment themes. For example, there is an ETF that invests in lithium, batteries, and battery technology stocks. This ETF holds battery manufacturers and suppliers as well as lithium end-user businesses. This diversification is particularly valuable in investments if there is an indication that one sector will dramatically outperform another; it allows an investor to buy a whole portfolio of companies within a defined investment theme.
Over the past few years, thematic ETF investing has grown significantly. This movement is an innovation growth factor for both assets and revenue within ETFs. Thematic ETFs seek to provide exposure to a trend or developing business model through the compilation of securities from multiple sectors. Themes are often global and encompass multiple businesses within the supply chain, which support the global growth trend. They can also target specific geographies. Also, most thematic ETFs are non-traditional indexes. Many thematic ETFs succeed because they bring liquidity and options to themes that are often difficult to trade. It is advisable to check the holdings of an ETF to be certain the theme is what you believe it is.
Pricing and Liquidity
Both mutual funds and ETFs trade against an underlying net asset value (NAV). The NAV is the computation of the collective value of all the underlying securities held by the ETF or mutual fund. In the case of most mutual funds, the NAV is computed from the closing prices of the underlying assets held at the fund and is posted after the market close. When investors enter a price to purchase a traditional mutual fund, that purchase price is based on the closing price at the end of the day, so the purchase takes place after the close before the market opens the next day. Some mutual funds have time restrictions on when the orders must be entered in the system; for example, there may be a set time in the afternoon for orders to purchase or sell shares taking place at the end of the day.
By contrast, the NAV of an ETF is computed intra-day as the shares of ETFs trade on the exchanges during the trading day. Some investors prefer to trade ETFs because intra-day trading allows them to react to changing market conditions that occur during the course of the trading day, while the mutual funds can generally only be bought or sold after the close of the markets.
Liquidity
ETFs trade like shares of stock. They are traded on the major stock exchanges and have both high levels of liquidity and intra-day pricing advantages. With an ETF product, it is possible to buy and sell at any time within the market day, allowing the investors to react in a timelier manner to relevant events. ETFs are generally more suitable as broad market trading vehicles and can be sold short while mutual funds cannot. With most mutual funds, pricing and purchases and/or sales occur at the end of the trading day. Thus, investors in mutual funds lack the ability to react quickly to news and events.
In many ways, however, this intra-day liquidity is an illusion. Since the purchase and sale of the ETF itself trades on the exchange continuously throughout the trading day, market pressures on the trading of the ETF may be separate and independent from the market pressures of the underlying shares. For example, if an uninformed investor enters a market order (as opposed to a limited price order) to purchase ETF shares, the investor may drive up the price of the ETF shares without corresponding movement in the aggregated price of the underlying holdings. This is particularly evident in highly focused ETFs with fewer holdings in their underlying shares.
Putting pricing pressure on the ETF, which has its own limited market pressures, creates a trading arbitrage between the price of the ETF and the price of the underlying shares. If the ETF is broad enough (with substantial underlying holdings) and the share of the underlying securities is liquidity-constrained, the prices may not be congruent. This type of arbitrage trading is generally fast-paced and computer-driven. What it does create, however, is a price movement that is not justified by a price movement in the underling holdings.
Fees
All else being, the structural differences between ETFs and mutual funds gives a cost advantage to ETFs. ETFs are usually considered passive investments where buy-and-sell decisions are made automatically. Such investing generally does not require the extensive research staffing of traditional mutual funds nor does it incur the structural expenses. As a result, they pass through their lower operating expenses to their shareholders.
One of the benefits of the growing trend towards passive investing is lower fees to the investor. Thomson Reuters Lipper pegs the average expense ratio at 1.4 percent for an actively managed equity fund, compared to only 0.6 percent for the average passive equity fund. Not only do passive ETFs generally charge lower fees, but the competition is driving the passive fees lower. Active ETFs tend to have fees somewhere in between the passive ETFs actively managed mutual funds.
Minimum Investment Thresholds
Mutual fund minimum initial investments aren’t based necessarily on the fund’s share price. Fractional shares are available and so the investment can be based on a flat dollar amount. They can vary depending on the type of fund and the fund company. Thus, some mutual funds have minimum investment requirements that can run into thousands of dollars. ETFs, on the other hand, can be purchased for as little as one share. But the investment is made in share units, and so it is fixed at the price per share.
Tax Treatment
From the perspective of the Internal Revenue Service, the tax treatment of the purchase and sale of individual ETF shares and mutual fund shares are the same. Both are subject to capital gains tax and taxation of dividend income. Most people are familiar with this tax liability.
Investors, however, incur capital gains tax liability two ways: first, when they buy and sell the ETF or mutual fund and second, when the underlying investment shares within the fund are bought and sold. When investors buy shares in a mutual fund or ETF and then sell those shares at a profit, that capital gain is paid by the investor. When a mutual fund or ETF itself has a holding that the fund buys and then sells at a profit, that capital gain is passed to the shareholders in the case of a mutual fund, but not necessarily in the case of an ETF.
For trades occurring within the mutual fund wrapper, the tax liability is a different story. With mutual funds, the fund manager can sell securities at any time to rebalance the fund or to re-allocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders and that liability is passed through to the shareholders in their proportionate interest For example, if there are 10 shares, then the liability is divided in tenths.
What this means is that, even for shareholders who may have an unrealized loss on the overall mutual fund investment (because the shares of the fund fell below the purchase price of the shares), investors could incur a tax liability of the gain produced by the sale of a stock position within the mutual fund without incurring the appreciation in share value, or while not benefiting from the appreciation in share value if the underlying security continues to rise. If this is coupled with a collapsing market and investors liquidating their shares of the fund, the impact is amplified as the taxable liability is distributed among fewer shareholders of the mutual fund. In this example, the tax liability, rather than being divided by the original shareholders, would be divided by those remaining.
In contrast, an ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, the investor usually is not exposed to capital gains on any purchase or sale of an underlying individual security held by the fund.
The creation of new ETF shares and the redemption of those shares are handled by an “authorized participant,” which is usually contracted with the fund sponsor. The “authorized participant” creates what the IRS recognizes as an “in kind” redemption process for tax purposes with the ETF, which does not necessarily mean the ETF generates a tax liability for shareholders of the ETF when the underlying shares are sold. The aim is to mimic the index, and any changes that must be incurred to mimic that index should not be taxable.
This tax haven is currently extended for ETFs because the investment process is thought of as a passive investment process, where a basket of shares are bought to simulate an index, and such changes would be an index change event. If the ETF benchmark index changes its underlying holdings, then the fund must also make the change. The theory is that the trading gains that come from changing the ETF to stay congruent with the index should not be taxable. As such, when a fund sees excessive liquidations in effect, it can liquidate without incurring the same tax liability to shareholders as a traditional mutual fund.
The mutual funds have to pass through in-fund gains to the shareholders in the form of a tax liability while the ETF fund, if regarded as a passive fund that mimics an index, does not. So far, more actively managed ETFs with higher turnover or more detailed models and objectives do not necessarily have this advantage; however, there is currently a proposal to broaden the definition of a passive ETF, which would offer this tax advantage to the more actively managed ETF funds. This proposed expansion has not yet been enacted. The mutual fund industry is lobbying for similar tax-advantaged treatment for mutual funds as well.
From a tax perspective, not all ETFs are created equal. Though equity and fixed income ETFs are generally treated similarly regardless of structure, commodity ETFs, for example, can be taxed at a much higher rate than mutual fund holdings.
ETFs Are Here to Stay
Ever-increasing cash inflows into the ETF market demonstrate the attractiveness of these products despite the shortcomings of those offerings. These investments are here to stay and it will likely take a significant downdraft in the market to clearly demonstrate and amplify market fluctuations. Like all new investment vehicles, ETFs will have to be challenged, tested, and then explained.
As with any investment, it is important to understand a specific product before making the investment. There are places in a portfolio for mutual funds and ETFs. Please consult with your financial adviser before making any investment.
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