by WWM | Sep 5, 2018 | Exchange Traded Funds
One perceived advantage of exchange traded funds (ETFs) over open-end mutual funds is their greater trading flexibility.
Many investors believe that there are also advantages in respect of ETF costs. Specifically, expense ratios, transaction costs, and tax efficiency. As with trading flexibility, the potential advantages will vary between investors depending on their investing tactics. I will lay out the reality and you can decide if there is a benefit for you.
We will cover annual expense ratios below, with transaction costs and tax efficiency next week.
ETFs tend to have lower expense ratios than open-end index mutual funds that track the same benchmarks.
That is a fact.
But, like most things, there is a little more to it than that.
Expenses Can Differ Between Funds
The difference between index fund expenses can vary to some degree. And when you include actively managed funds in a specific category, the differences can be substantial.
Consider the Standard & Poor’s (S&P) 500 index. The S&P 500 is considered a Large-Cap Blend investment style.
Per Morningstar data as at September 4, 2018, the average expense ratio for funds in this category, which includes both actively managed and index funds, is 0.99%. That is a lot of return paid back to the fund each and every year.
Being an average calculation, we will find both higher and lower expense ratios in this category.
For example, the no load Fidelity® Total Market Index F (FFSMX) has an annual expense ratio of 0.02%. On the other side, the no load American Century Core Equity Plus R (ACPWX) has an expense ratio of 2.35%. Quite the range!
One would hope that the higher cost funds outperform the lower cost ones. But that is not often the case. In the example above, over the last 5 years the Fidelity fund achieved an annual return of 14.22%. The higher cost American Century only averaged 11.38% per annum. And that is not cherry picking data.
Higher cost does not usually translate into better results. In fact, annual expense ratios are usually a drag on net returns. That is, higher cost funds do not outperform. Investing in low cost products tends to be the better route.
ETF Expenses Should Be Lower
Now if we compare these specific funds to certain S&P 500 ETFs, we see even lower costs with the ETFs.
That said, over the last few years, mutual funds have really tightened the costs on their index funds. Primarily in response to investor cash flowing out of mutual funds and into the less expensive ETFs. We saw that in out example above with Fidelity. As well, behemoths like Vanguard and iShares also offer very low cost mutual funds.
You will also find higher cost ETFs as their fund companies branch into actively managed ETFs. As well, more niche asset classes that cost more to administer.
But, if we consider plain-vanilla S&P 500 index ETFs, on average they will be less costly than mutual funds. For example, Vanguard S&P 500 ETF (VOO) and iShares Core S&P 500 ETF (IVV) each charge only 0.04% per annum.
Keys to Remember
From this, I suggest you take away five points.
One, there is a significant variation in expense ratios between open-end mutual funds in any given investment category. This is true for both actively managed funds and index funds. Make sure you do some comparison shopping before investing. Giving up 1.0% or more in return due to expenses is not a prudent way to accumulate wealth.
Two, there is some variation between the expense ratios of even the lower cost open-end index mutual funds. It may not be substantial, but still compare between index mutual funds.
Three, while ETFs currently have lower expenses than index funds, the gap has narrowed greatly in recent years. Do not automatically assume that you will save more money with an ETF over an open-end index fund. Depending on your investment tactics, you may not.
Four, expense ratios may vary between ETFs. While a top ETF should have lower costs than a top mutual fund, not every ETF may beat every index fund on cost. Make certain you choose wisely when selecting ETFs.
Five, cost minimization is crucial. But do not confuse that with getting value for your money. While an ETF may have the lowest expense ratios, there may be other factors that make open-end index funds preferable for your needs. Transaction costs are one such factor. We will review these, plus tax efficiency, next post.
by WWM | Aug 30, 2018 | Exchange Traded Funds
Some investors perceive advantages in utilizing exchange traded funds (ETFs) versus open-end index mutual funds.
Depending on the investor, some of these may be more important than others.
Or possibly these potential benefits may actually not entice an investors to choose ETFs over open-end index mutual funds. I write, you decide.
Today we will consider potential ETF trading advantages.
Active or Speculative Trading
Active traders like ETFs over open-end funds.
ETFs are traded intraday so traders can each buy and sell the same ETF multiple times in a single day if they so wish.
With an open-end fund, traders may only buy or sell fund shares after the share’s closing net-asset value (NAV) is calculated. For most funds, that is once daily, but not for all funds.
If you want to potentially day trade indices on various asset classes, ETFs are preferable.
While most readers are not day-traders, at times it is beneficial to be able to buy or sell during the trading day. For example, perhaps the market is falling significantly. You might be able to sell your ETF shares in the morning, thereby receiving a higher sales price than if you had to wait until the end of the day as with an open-end fund.
Note that I differentiate between active traders (or day traders) and investors. I have nothing against those that want to trade often. But I consider this to be speculation, not investing (in the true sense of the terms). Further, it takes substantial time and effort to be a day trader and is best left to those with the expertise, investment tools, and extreme risk tolerance. Finally, the more one trades, the more transaction costs and possiblly taxes are generated. I would not recommend highly active trading for individuals seeking long-term wealth accumulation.
(Probably) Improved Liquidity
Having the ability to trade ETFs continuously during exchange hours usually makes ETFs quite liquid as compared to open-end funds that typically only allow purchases and redemptions once daily, after the closing NAV has been calculated.
For long-term investors, usually this is not a major issue. Long-term investors have lengthy time horizons and daily price fluctuations are not significant concerns. If you can trade once daily, I think that is adequate for most investors.
I would caution though that some mutual funds may not be valued daily. Rather, they may only be valued weekly or even at longer intervals. The longer the time frame between being allowed to buy or sell shares, the greater liquidity risk becomes a factor. If the fund you are considering only allows trades once a week or once a month, I suggest you consider ETFs as an alternative.
While ETFs tend to be more liquid than open-end funds, there is a caveat. Like common shares, to be able to buy or sell ETFs requires a counterparty. When you are selling, you need a buyer. If the ETF you are considering has a limited number of shares outstanding or is not listed on a major exchange, these may indicate that the ETF has liquidity issues.
On the flip side, assuming your mutual fund company remains solvent, you have a ready partner with which to buy and sell your mutual fund at NAV. With ETFs, you are subject to market forces which may cause liquidity (and pricing) issues.
Most popular ETFs will not normally have liquidity issues. If concerned, you can assess an ETF’s liquidity (or any exchange traded investment) yourself.
Check the average trading volume over daily and weekly ranges. If you intend to purchase 10,000 shares and the ETF only trades an average of 1,000 daily, it might be difficult to sell all your shares at prevailing market prices.
Further, review the bid-ask spreads for these ETFs. Spreads for liquid investments should be very close to each other. That means that investors do not have to budge greatly from their initial positions to close the transaction. But say you want to sell 10,000 shares at the last sale price of $10 per share. You post your ask price and wait for the sale to occur. Unfortunately, no buyers want to pay $10 for your shares. In fact, the closest bid is for 5,000 shares at $6. Either the interested buyer needs to increase his bid by 67% or you need to reduce your asking price by 40% or you both need to meet somewhere in the middle to do the deal.
Counterparty risk may also be a consideration against buying an open-end mutual fund. With most ETFs there is an adequate number of shares outstanding with a wide variety of investors present to buy and sell. However, with an open-end mutual fund you are buying and redeeming shares directly with the fund company. Should the fund company become insolvent, investors in funds of that company may have difficulties redeeming their shares.
So, before investing in an open-end mutual fund, I suggest you ensure that the fund company is in strong financial shape.
Trading Flexibility
ETFs offer greater trading flexibility than open-end mutual funds.
We already discussed above the increased possible frequency of ETF trades. But there are other potential advantages in trading ETFs.
As you trade an ETF exactly like a stock, you can enter a variety of trading orders. Besides buying or selling at the current market price, investors may engage in other tactics, including limit or stop-loss orders.
Open-end mutual funds are only purchased or sold at the fund’s per share closing NAV. You cannot put in orders at different values.
You can also short ETFs in many jurisdictions. That is, you “borrow” shares of the ETF and sell them in anticipation that they will fall in value. If the ETF price does decrease, you buy the shares back on the open market, give back the “borrowed” shares to the lender, and pocket the profit on the difference. Of course, if the price does not fall, then you will face margin calls and possibly steep losses when you close the short position.
You cannot short open-end mutual funds as you are buying and selling them directly from the fund company.
I think that being able to enter non-market orders is advantageous, especially when rebalancing one’s portfolio. That said, if you are investing for a lengthy period chances are that buying or selling based on NAV will not impact on your returns.
As for shorting, or using margin accounts in general, I do not think they are necessary to create a strong portfolio.
Next, a few more areas where ETFs are considered preferable over open-end mutual funds.
by WWM | Aug 22, 2018 | Exchange Traded Funds
Another popular way to passively invest is through exchange traded funds.
Today we will discuss exchange traded funds and how they differ from similar investments.
Exchange Traded Funds
Exchange traded funds (ETFs) share traits with a few investments. But there are also significant differences.
ETFs are funds that invest in a collection of securities or derivatives. ETFs may be passive, in that they attempt to replicate the performance of a benchmark index. As well, there are an ever increasing volume of actively managed ETFs. Almost exactly like mutual funds.
Certain ETFs pursue targeted investment strategies. For example, leveraged or inverse ETFs. For now, we shall avoid discussion of the more exotic varieties of ETF.
ETFs have a fixed number of shares outstanding.
These shares trade on authorized exchanges and can be bought or sold continuously during open exchange hours. ETF shares trade directly between investors who buy and sell through their accounts in a brokerage house.
As trades are conducted via broker, commissions are paid when ETFs are bought or sold. However, no sales loads are charged on any ETF acquisitions or dispositions. As well, brokerage firms may waive transaction costs on some ETFs.
The price of the ETF shares is determined by investor supply and demand in the open market. No closing net-asset values are calculated for ETFs. Instead, ETF share prices fluctuate throughout each trading day based on trading activity. That said, ETFs normally trade close to their net asset values.
Compare with:
Open-End Index Mutual Funds
Open-end index mutual funds are also structured to replicate a benchmark index. In performance, gross returns should be similar to an ETF with the same benchmark index.
Open-end funds do not have a fixed number of shares or units. As new investors subscribe for shares (or units) of the mutual fund, new shares are created to reflect the addition of capital.
Open-end mutual fund shares are purchased and redeemed directly through the mutual fund company, not from other investors on an exchange.
Investors buy and sell open-end mutual funds at the fund’s closing net-asset value. Investor supply and demand has no impact on the price of the fund’s shares.
While ETFs may be traded at any time the exchange is open, open-end mutual funds only trade upon calculation of the net-asset value. For most funds, this is daily, but it can be less frequent. So open-end funds may be less liquid than ETFs.
When buying or selling open-end funds, investors may be charged a sales fee or load. Further, if one trades via their brokerage account, the trades may be subject to a broker’s commission as well. ETFs do not have any loads, only commissions on trades.
Common Shares
A company’s common shares trade on authorized exchanges or over-the-counter any time the exchange is open. A share’s price is determined by investor supply and demand for the company’s fixed number of outstanding shares. Net-asset value is irrelevant to the share price.
Shares are bought and sold through one’s brokerage account and traded directly with other investors. There are no loads, but the broker will charge a commission on any trades made.
While an ETF trades exactly like a stock, the obvious difference is the asset itself.
Whereas the ETF is a diversified portfolio of investments that seeks to replicate an index, shares are single, non-diversified investments. Depending on the company’s correlation to different indices, the shares may or may not move in tandem with a specific index.
Closed-End Investment Funds
Closed-end investment funds (CEFs) also have a fixed number of shares and trade on exchange throughout the business day. And the price of CEF shares is also determined by investor supply and demand.
There are index CEFs that replicate benchmark indices.
No loads are paid, but brokerage commissions are charged.
CEFs are essentially the same thing as an ETF. However, technically, they are not ETFs.
Okay, there are some similarities and differences between ETFs and open and closed-end index funds. Big deal.
The key question is, what is the attraction of ETFs to investors?
We will look at that next.
by WWM | Aug 15, 2018 | Mutual Funds
Many investors passively invest using open-end index mutual and exchange traded funds.
Some investors lump the two instruments together when discussing passive holdings. And there are a lot of similarities when assessing for investment potential.
But there are also material differences between the two, so I shall discuss them separately.
Today, a brief look at open-end index mutual funds.
An Index Fund is Still a Mutual Fund
An index mutual fund, or “tracker” fund, is exactly like any other open-end mutual fund.
There are mutual funds that invest in U.S. large capitalization stocks, Russian bonds, Canadian mining companies, etc. Pretty much any type of investments one can configure.
An index fund simply invests in a designated benchmark index for a specific investment style.
For example, the BlackRock iShares U.S. Aggregate Bond Index Fund (BMOAX) is a fund that attempts to match the total return of the Barclays U.S. Aggregate Bond index. The Fidelity® Emerging Markets Index Fund (FPEMX) seeks to replicate the MSCI Emerging Markets Index.
We have spent a fair amount of time discussing open-end mutual funds. If you want an in-depth analysis, please take a look at Mutual Funds in my category listing on the right.
I will briefly go through some of the key points and try to cross-reference to any specific posts for greater detail.
Open-End
Open-end funds are purchased and sold through each fund’s company.
Unlike most investments, you do not acquire open-end mutual funds on a stock exchange. However, often you can buy and sell open-end funds through your brokerage account as many brokerage houses will act as intermediaries between you and the mutual fund company.
If not, you need to create an account with the fund company. Something they love as your money becomes a sticky asset.
Note that investors tend to stick with a fund company (or financial institution) even if performance or client service is not great once their assets are in place. Clients find it too much a pain to go through the process of moving to a new institution. Needless to say, financial institutions often create obstacles as well that deter clients leaving painlessly (e.g., perhaps 60 days to transfer to a new institution).
Before committing to an individual financial institution (bank, fund company, etc.), realize that you may be with them for a long period. Take care before committing your assets.
Transaction Costs
A goal of passive management is cost minimization.
This should be followed in respect of any mutual fund transaction costs.
In most cases, avoid mutual funds with loads. This is especially true for index funds. Paying a sales charge for an index fund is not justifiable in my opinion.
Be careful with any brokerage commissions you are charged when trading through your account. If you invest directly through the mutual fund company, you should not be subject to commissions on trades.
Some brokerage houses offer commission-free mutual funds. Consider these as well when looking at index fund offerings.
Annual Costs
Look for index funds with low operating costs, as indicated by their expense ratios.
Passively managed index mutual funds should have little to no management fees attached. Do not pay for a service that you are not buying.
All mutual funds incur some administrative and other operating expenses. But focus on those with low expenses.
Note that larger funds or fund companies tend to exhibit economies of scale. The larger the fund, the easier it is to spread out fixed costs among investors. That tends to lower overall expense ratios. In large part, why behemoths like Fidelity, BlackRock, and Vanguard, have such low expense ratios. And competitive advantages versus smaller peers.
Match the Market Return
When assessing funds for investment, always compare a fund’s returns against its benchmark and its peers. Remember that performance is a relative concept and you need to analyze investments in proper context.
Find funds with minimal tracking error, that match the benchmark index return as closely as possible.
Risks of Open-End Mutual Funds
Counterparty Risk
As the contractual relationship is between you and the fund company, be certain you minimize the counterparty risk.
You can only sell your shares back to the fund company. Not to a multitude of potential buyers via a stock exchange. Try to be sure that the fund company will be in existence and able to repurchase your shares when you want to sell them. Note that counterparty risk may also be known as default or credit risk.
Liquidity Risk
Normally fund companies calculate a fund’s per share net-asset value (NAV) daily using closing market prices for fund holdings. And most fund companies let investors buy or sell fund shares on a daily basis at a fund’s NAV.
However, some funds may not perform valuations on a daily basis nor allow for acquisition or divestment of fund shares daily. These funds may only allow redemptions on a weekly (or longer) basis. If the market you are invested in suddenly plunges, you may be unable to sell in a timely manner.
Know the frequency in which you may buy or sell shares. The less opportunity that you have, the greater the liquidity risk.
Over-Concentration Risk
When investing in multiple index funds, watch your portfolio diversification.
Depending on the indices you invest in, there may be an overlap of securities. This may create an over-concentration of certain investments and actually reduce diversification. Always monitor the key holdings in each fund you own.
For example, Apple is present in (it seems) every US equity fund. Even if you spread your wealth around, you will own Apple in multiple funds. Watch for potential over-concentration of one investment over all your holdings.
You will also find that, in many funds, the top 10 or 20 holdings will make up a disproportionate share of fund assets.
Consider BlackRock iShares S&P 500 Index Fund (BSPAX). 500 U.S. listed companies across a variety of industries. Nice diversification. But if you review the portfolio, the top 10 companies make up 22.35% of fund holdings. Not quite as diverse as you might initially think. And yes, that ratio holds true for any S&P 500 Index Fund, not just iShares.
Here, we also see Apple and its market dominance. Out of 500 companies in the index, Apple alone accounts for almost 4% of total fund assets (as at August 13, 2018). Always an issue with capitalization weighted indices.
Note that while the S&P 500 represents a relatively large market, this tends to be a bigger issue the smaller and/or more niche market covered by an index.
South Korea is always a good example. iShares MSCI South Korea ETF (EWY) owns 114 different companies. Samsung alone is 22.28% of total fund assets as of August 13, 2018. Not to mention, many other Korean companies in the index are reliant on Samsung for their own business. While you may own the South Korean market as a whole, in reality your risk is heavily tied to the fortunes of Samsung.
Note that this South Korea fund is not a mutual fund. Next up we will start to look at the other popular passive investment, exchange traded funds (ETFs).
by WWM | Aug 8, 2018 | Active vs Passive Management
A goal of passive investing is to match the market return as closely as possible.
However, it is not a given that a passively structured investment will match its own market. In fact, there may be material variations between different investments and the benchmark index performance.
Index funds (both mutual and exchange traded) are typical passive investments. Here is why they do not normally exactly match their benchmark returns.
Operating Costs
Index funds incur operating costs that are not present in the benchmark index.
While there may be little to no management fees charged, there will still be expenses for: commissions on buying and selling securities; accounting for fund assets; shareholder communications; regulatory filings; staff salaries; etc.
These costs cannot be avoided. Any fund that you invest in will be at an immediate disadvantage in trying to match the market return.
The more efficient the fund, the lower the relative costs. As well, there is often economies of scale for larger funds. Operating costs cannot be avoided entirely. But be sure to compare funds before investing. There will be differences.
Transaction Timing
Even if we could avoid all fund costs, it still may still be difficult to exactly match the benchmark index performance.
Securities need to be bought and sold on the open market to properly track an index.
For example, per a June 19, 2018 S&P Dow Jones Indices news release, “Walgreens Boots Alliance Inc. (NASD:WBA) will replace General Electric Co. (NYSE:GE) in the Dow Jones Industrial Average (DJIA) effective prior to the open of trading on Tuesday, June 26.”
If you are an index fund that mirrors the Dow 30, you may need to sell your holdings of General Electric and replace them with Walgreens. There is no guarantee that the price you receive for General Electric, or pay for Walgreens, will be the same as calculated by the benchmark as at the close of business on June 25. This likely will create a variance in fund performance versus the benchmark.
Compounding this problem is that there are many funds that track this index.
The more funds that reflect a specific index means more competition for shares of securities added to an index and more sellers of securities that have been removed from an index. If there is suddenly either increased supply or demand, it can cause significant price fluctuations.
When a fund can invest and divest securities may have an impact on its performance versus the benchmark. Think of the price impact on General Electric as all the tracker funds holding this stock sell their shares. And what will be the short-term price impact on Walgreens as these same funds buy all available shares of this stock?
Obviously, the smaller and/or less liquid an index, the greater the fluctuations likely between purchase and sale prices on equities entering or leaving the index.
Fund Construction
Variances between performance in the benchmark and index funds may relate to how the fund is structured.
Not all index funds are created equally.
Index funds may be created using full, partial, or synthetic replication.
Full Replication
Full replication involves holding every security in the index in its appropriate weighting.
With complete replication, an index fund’s gross returns should be close to to the index itself.
As the relative weightings of securities can fluctuate based on security price and capitalization, to stay fully replicated may require frequent trading. How quickly the fund can adjust its portfolio will impact matching gross index returns.
Also, increased trading will increase fund operating costs. This reduces fund performance versus the actual index which does not incur any expenses. The increased fund turnover can also create taxable capital gains for investors, once again impairing net returns.
Partial Replication
Partial replication does not hold all an index’s securities. Instead, it only maintains a representative sample of the securities within the index.
The better the sampling techniques, the closer the gross returns should be to the index. But when not fully replicating an index, there is a greater risk that actual returns will deviate from the actual benchmark or a portfolio using full replication.
This is known as the index fund’s tracking error.
Tracking error is not a one way street. It can also result in a fund achieving higher gross returns than the benchmark.
An advantage of partial replication is that by owning fewer securities, there is less trading (and transaction costs, administration expenses, triggering of capital gains, etc.) than under full replication.
Whether partial replication is preferable to full depends on the quality of the sampling technique.
Synthetic Replication
Whereas full or partial replication requires the fund to own all or some of the benchmark index holdings, synthetic replication does not.
Synthetic replication uses financial instruments to replicate the index performance. These may include the use of futures, swaps, and other derivatives.
An advantage of synthetic replication is that it is usually easier and more cost-effective to re-create and manage the benchmark using financial instruments rather than investing in individual securities.
There still may be some tracking error in performance depending on the specific benchmark index and the availability of financial instruments. For established markets though, tracking error should be small.
A potential problem arises for less established markets where finding an exact match of financial instruments is not simple. In these instances, the fund may need to rely on a less than perfect fit in trying to replicate the market. This will increase tracking errors.
Also, it may require the fund to enter into swaps with other entities to replicate the benchmark index. This creates counterparty risk (risk that one side of the transaction will not fulfill its obligations) and can impact fund performance should the counterparty default.
While trading and administrative costs are reduced with no actual securities being owned, there are still costs associated with a synthetic strategy. These include fees associated with the financial instruments used. In established markets, there are many options for replication, so the costs tend to be reasonable. But in less established markets, it may not be as easy to find replication solutions and the costs will rise.
It is not imperative that you memorize the mechanics of fund construction. It is simply a reality of index funds.
But always keep in mind that a passive investment may not exactly match the return of the market it represents. And the reasons for that lie (mainly) in the above points.