Open-end mutual funds and exchange traded funds (ETFs) are the two most common ways to invest in passive index funds. How are they similar in investment characteristics? How do they differ for investors?
“What are trading considerations with ETFs and mutual funds?”
ETFs trade on public exchanges. You can buy or sell at any time in the trading day. Open-end mutual funds, as opposed to closed-end funds which we will not include in this discussion, are bought and sold directly with the fund company. With the majority of funds, being tradable at close of day net asset value.
If you are an active trader, who wants to jump in and out of investments, the ability to continuously trade may make ETFs more attractive. For most long-term investors though, this is not an issue.
“What about liquidity?”
ETFs can be traded continuously, whereas mutual funds can only be liquidated in set time periods. Often, end of day valuations. But in some funds, less frequently.
So ETFs are more liquid.
Or not.
If you own an ETF that is thinly traded or has little market capitalization, it may be difficult to find a buyer or seller to trade with. The harder it is, the greater the bid-ask price spreads, which impact asset liquidity.
Whereas, unless your fund company is insolvent, you always have a ready partner to buy or sell mutual fund units.
It is prudent to invest in ETFs with significant assets under instrument, that trade on established stock exchanges. With mutual funds, consider fund companies that are well established, with strong finances.
“What about transaction costs? Sales commissions, brokerage fees, and so on?”
ETFs are traded on stock exchanges. Usually there will be a brokerage commission charged on each trade. Today, that may be under $10 per transaction, regardless of the volume. Of course, that is through an online broker, not a full-service one. So shop around when deciding on the brokerage house to use.
Some brokers offer certain “no-transaction fee” ETFs, where the trading costs are waived. Not an extensive list. Often not “best of class” ETFs. But something to consider when weighing which ETF to purchase.
Mutual funds do not incur brokerage fees. But you may be charged a sales commission, or load, when buying or selling a fund.
Research data indicates that sales commission funds do not provide superior performance over no-load funds. And that is definitely true for simple, index funds. Unless you plan to invest in some extreme-niche index, never pay a load for an index fund.
“Taxes are another cost. How do ETFs and mutual funds compare on tax efficiency?”
Tax treatment varies on a jurisdiction by jurisdiction basis.
Often, ETFs offer better tax efficiency. But investors should consider their own tax jurisdiction and personal situation. Then factor that into the cost analysis.
“What about Management Expense Ratios (MERs) differences in mutual funds and ETFs?”
ETFs, on average and over time, have enjoyed lower MERs.
But that can be a tad misleading. Historically, mutual funds tended to be actively managed. ETFs were more passive. One would expect a cost gap given the lack of management fees in the passive ETFs.
But even comparing apples to apples, ETFs still tend to maintain a cost advantage. Not always. And there are other factors that come into play. Economies of scale being the big one.
Do not automatically assume that ETFs will be less expensive. Within an asset class or subclass, assess across all passive investments in comparing net performance and cost structure.
We will end our look at exchange traded funds (ETFs) with a few words on fund of funds.
Fund of funds are also available with mutual funds. My comments apply equally to them.
Fund of Funds
As the name indicates, an investor purchases an ETF (or mutual fund) whose holdings consist solely of investments in other ETFs (or mutual funds).
In this sense, it is the same as life cycle ETFs. However, fund of funds maintain their stated asset allocations, they do not adjust the mix over time.
Or similar to ETF wraps. But with less flexibility regarding changing asset allocations within the overall fund.
For example, consider the iShares Morningstar Multi-Asset Income ETF. It invests in a multitude of iShare funds (10 at the time of writing this post) aiming for a target asset allocation of 60% bonds, 20% stocks, and 20% alternative assets.
Advantages
Simple
I think simplicity is the primary advantage.
You do not need to buy multiple investments in order to create a diversified portfolio. You simply purchase one that matches your desired asset allocation. Further, the fund of funds automatically adjusts its holdings to maintain the stated mix. Instead of monitoring and assessing many investments, you only need to track the one ETF.
Relative Cost Effective Diversity
Secondly, because fund of funds invest in other ETFs, the holdings are relatively cost effective and efficient investments. Relative, that is, compared to active management strategies or holding mutual funds.
Plenty of Options
Thirdly, there are a wide variety of fund of funds available. You should be able to find one that meets your specific investment objectives. Whether that be a simple split between cash, fixed income, and equities, or something more complex.
Of course, if your target asset allocation changes, and it will over time, you may need to sell the entire fund of funds. Rather than just fine tune a few of the sub-funds to meet your new needs.
Disadvantages
Management Fees
For me, a problem with fund of funds is always the incremental costs involved.
A major advantage of ETFs, in general, is their relatively low expense ratios. But as complexity increases, fees also rise.
Also, you need to watch for double dipping. The investments held by the fund of fund are also ETFs (or mutual funds), which have their own fees and expenses. Given increased competition, often these are adjusted down, but there is still the possibility of paying twice for the same service.
Be sure to compare annual fund of fund costs versus investing in the individual funds that make up the fund of funds before committing.
Potentially Not the Best Investments
It can also mean that the fund is not investing in the best available ETFs. Rather, the prime criteria for ETF selection is the issuer of the individual ETF.
In the iShares Morningstar Multi-Asset ETF I linked to above, all 10 sub-funds are iShare ETFs. Which makes sense given it is an iShare fund of funds. But are all 10 sub-funds the “best in class” that you would buy individually?
There are differences in performance and costs between different ETFs within the same category. I would rather select the best available ETF in a specific asset class, not simply choose the ETF because it is from the same company as the fund of funds.
Conclusion
In general, I tend not to use fund of funds. It is not usually difficult to set up a target asset allocation and choose “best in class” ETFs from across a variety of issuers. That way, I get the best individual investments and save some costs.
That said, there may be niche markets or areas where it does make sense to use a fund of fund. As competition for client money continually increases, ETF issuers are reducing/eliminating double dipping and trying to keep costs in line.
The key is to find strong investments that meet your personal objectives on a cost effective basis. That may be a fund of fund. But more often I think, you are better off building your portfolio from individual ETFs.
Today we will look at life cycle or target date funds. These funds ebb and flow, it seems, in popularity. A few years ago, there were many. Today, less so. Maybe over the next decade we will see a resurgence.
In this post we will focus on exchange traded funds (ETFs). But there are also life cycle and target date mutual funds.
Some technical differences between the two, but the fundamental principles are the same.
What is a Life Cycle ETF?
There are two keys to life cycle ETFs.
Retirement Date
The ETF is based on an expected retirement date for investors.
That “target date” is normally part of the fund’s name. Investors choose an ETF that corresponds to their specific retirement timeline. For example, you are 30 years of age in 2020 and intend to retire at age 65. So you would select an ETF with a target date of 2055.
While primarily used for retirement planning, they can also be used for other objectives with fixed future dates. Examples might be: weddings, home purchase, children’s college fund.
Asset Allocation
These funds use asset allocation techniques that shift over the life of the fund.
We will cover asset allocation later as it is crucial for investment success. Even more important than the actual investments that you select.
When young, there is a long time horizon until retirement. As such, young investors can tolerate greater volatility (i.e., risk) in their portfolios in the pursuit of higher expected returns.
As investors approach retirement, they want to lock in their portfolio gains. Further, they wish to reduce the uncertainty over the amount of capital they will have at retirement.
With life cycle ETFs, the fund invests in higher risk assets initially. As time to the target date decreases, the fund shifts its investments into less risky assets.
A major lure of life cycle ETFs is the ability to put your capital in one investment and (almost) forget about it until retirement.
You can set up automatic deductions from your chequing account and invest in this structure every month. The fund managers adjust the portfolio periodically to ensure that the time sensitive asset allocation targets are met.
ETFs are also less expensive to own than paying a professional to pick individual equities, bonds, and other assets as part of one’s portfolio.
Cost Effective
It is highly questionable as to whether professional asset managers can actively outperform a passive investment strategy.
For most investors, I would recommend taking a passive approach. Therefore, utilizing ETFs and open-end index funds are the preferred course over paying a professional.
Life Cycle Approach (Generally) Works
This is the way to successfully invest over the long run.
The use of asset allocation strategies based on one’s phase of the life cycle, that is. Not necessarily the use of life cycle funds.
Why Not Use Life Cycle ETFs?
Not Costless
I also believe that cost minimization is crucial to wealth accumulation.
While ETFs are generally less costly than mutual funds and active management, there are still annual fees and expenses charged for life cycle ETFs.
You are paying for someone to purchase and adjust ETFs over time on your behalf. Something that you should be able to do for free.
Additionally, life cycle funds invest in other ETFs. These ETFs have costs of their own. So you run the risk of paying twice for operating costs.
Investors May Not Be Homogenous
Life cycle ETFs make assumptions about generic investors based on an expected retirement date.
But investors are individuals and not all cut from the same cloth.
Some investors may be more risk averse than others. Some investors may expect to live a long life after retirement and will want to continue seeking higher returns through riskier investments. Or perhaps other priorities – children, health issues, career interruptions, home purchase, etc. – come along that require individual investors to deviate from the life cycle planning of the generic investor.
Deviations in your personal life from that of the generic investor can complicate the simplicity of investing in only one product and forgetting about it until retirement.
Invest and Forget
Investment companies love this concept.
Some investors love this concept.
I would suggest smart investors be more cautious about “invest and forget” investments.
Regardless of the investment, you always need to monitor its performance. Not just in absolute terms, but against its peer group, designated benchmarks, and its expected return versus risk profile.
While I do not expect investors to study charts and data daily, you should always review your holdings at least annually. Quarterly or semi-annually is even better. Should there be issues with certain investments, you will need to take action.
“Buy and forget” is not the answer to successful results.
Conclusion
So those are the pros and cons of life cycle ETFs and, to a similar extent, life cycle mutual funds.
Another relatively new investment concept, I have not seen long-term performance data. So I cannot comment on their net or relative results.
Given the investment strategy, you should invest for the long-term. Do not plan to be actively trading these funds.
Also, the investment strategies employed encompass a wide variety of asset classes and take a holistic approach with the investor. If you have other investments outside the life cycle fund, you need to monitor the fund to ensure that you do not over-invest in any one area. Otherwise the efficiency of your total investment portfolio may suffer.
I do like the simplicity of these investments. And for many people, the easier something is, the more likely they will partake.
However, I think that the average investor can easily create a well diversified portfolio of ETFs or index mutual fund encompassing all necessary asset classes. Then, through periodic monitoring and rebalancing to reflect your unique objectives and constraints, you can replicate what these life cycle funds achieve.
And without paying a management fee.
As to how one should set up an investment strategy, we will come to that in the new year.
Exchange traded fund (ETF) wraps are another product you may encounter.
Relatively small in number, ETF wraps are gaining some popularity.
Not a topic to spend much time on, but I want to expose you to this investment approach.
Also, you can add a few useful investment terms to your vocabulary.
ETF Wrap
Whenever you see the term “wrap”, think of the associated product as a mix of investments wrapped together in a package. In this case, ETFs are lumped together and sold to investors.
How the ETFs are grouped for investment purposes may be the result of decisions by either the investor or a professional asset manager.
With investing accounts, always remember the term “discretion” Discretion is the ability to choose a specific course of action.
Discretionary Account
In a discretionary investment account, the asset manager chooses the specific ETFs held in the investor’s portfolio.
With an ETF wrap, the investor selects from a range of asset allocation options (e.g., 100% Canadian equities; 100 % Global equities split 10% Canada, 40% U.S., 50% other; Balance portfolio of 60% equities, 40% fixed income). The variety offered (and fees!) may differ between asset managers, so comparison shop if you want a managed, discretionary, ETF wrap account.
Once the investor decides on the mix, the asset manager makes the day to day decisions within those parameters.
Non-Discretionary Account
In non-discretionary accounts, the investor makes all the decisions. There may be investment advisors who provide advice and recommendations, but the selections lie with the investor alone.
As with ETF wrap discretionary accounts, the investor has to initially choose an asset mix.
But then the investor must also make the decisions as to the specific ETF investments among the available options. So there is more work involved for the investor.
Advantages
The arguments for using an ETF wrap account are the same as in all ETF versus open-end mutual fund discussions: often lower total expense ratios; no-loads or sales charges; increased liquidity; possible tax efficiencies.
As we have previously seen, these advantages may be true on average, but there are significant variances between individual ETFs and mutual funds. So do your analysis and due diligence.
With ETFs generally less costly than mutual funds, you can get professional management for less cost. The lower ETF costs may offset the money paid for asset management.
Further, the asset managers are only selecting investments from the pool of available ETFs. Compare this with mutual fund managers or asset managers in discretionary equity accounts. These managers must analyze a substantially larger investment set when making decisions. This increases their workload and should increase their costs and management fees relative to a manager that only needs to select from ETFs.
As such, professional management of an ETF wrap account should be cheaper than in an actively managed mutual fund or equity account.
Disadvantages
With discretionary ETF wrap accounts, you are paying for portfolio management, operating, and administrative costs.
Yes, management fees for ETF wraps should be less than in an actively managed account, but you are still paying for a service you may not need.
Conclusion
If this is something you think makes sense for you, feel free to invest in ETF wrap accounts.
I think though, that as your investment knowledge strengthens, you will be comfortable managing your own investment portfolio (made up primarily of ETFs and no-load open-end index mutual funds), so that you do not want to pay extra costs for these accounts.
We initially reviewed passively managed, index exchange traded funds (ETFs). These make up the vast majority of ETFs.
But there are other, less common, ETFs out there. We have looked at both actively managed and leveraged ETFs.
Next in the progression is inverse ETFs.
Inverse ETFs
Like normal index ETFs, inverse ETFs also track a specific benchmark index. But the objective is to move in the exact opposite direction of the index.
Through the use of derivatives and advanced trading strategies, inverse ETFs essentially create short positions on the benchmark index. These ETFs profit when the benchmark index decreases in value. If the Standard & Poor’s (S&P) 500 falls 5%, an non-leveraged inverse ETF, such as the ProShares Short S&P500 (SH), should rise approximately 5%.
The definition of inverse ETFs has some flexibility. It often includes funds that employ leverage to enhance short positions and accelerate relative returns. For example, Direxion Daily Financial Bear 3X Shares (FAZ) utilizes significant leverage to short shares in the financial sector.
Unsurprisingly, inverse ETFs are also known as “short” or “bear” ETFs.
Not a large investment category. I count only about 133 inverse ETFs in December, 2018 (others may find slightly more or less, depending on how one defines “inverse”). But given market uncertainty, there is some investor demand for these products at the moment.
Advantages of Inverse ETFs
Markets Do Not Continuously Rise
If you believe that a specific market will decline over a certain time period, inverse ETFs give you the opportunity to profit from a short position.
Some investors wish to pursue bear market trading strategies in anticipation of a negative market. Other investors want to use inverse ETFs to hedge their long positions in the market.
Professional Management
I am not an advocate of paying for professional management. However, I also do not recommend trading derivatives and shorting securities for many non-professional investors.
If you plan to engage in these activities, it may make sense to pay a professional to do it for you.
That said, many of these inverse ETFs are passively managed. There is no management other than ensuring the market is (inversely) tracked as dictated by the fund prospectus. However, there will be higher fees than a non-inverse ETF due to increased operating costs involved.
No Margin Required
If you short individual securities or indices, you require a margin account. But investing in inverse ETFs does not necessitate opening a margin account and worrying about margin calls.
Additionally, shorting securities within a margin account can be extremely risky.
In theory, shorting a single stock can result in an infinite loss to the investor. This would occur if the share price continued to rise and the investor was not able to close his position. Not a practical concern for most investors, but there is the possibility for significant losses should the share price rise sharply in a short period.
With inverse ETFs, there is no possibility of an infinite loss. At most, you will lose the money used to buy the ETF. Your loss will cap at 100%. Not good, but better than 1000% or more.
Good Variety of Inverse ETFs
Finally, there are a variety of inverse ETFs available. Should you so desire, you can short broad market indices, index subcategories, or countries and regions.
Some investors utilize inverse ETFs to target specific sectors or commodities for speculative, hedging, or commercial purposes.
Disadvantages of Inverse ETFs
Increased Complexity, Increases Cost
As with other more complicated ETFs, the greater the work involved, the greater the expenses.
When we looked at long ETFs that track the S&P 500, we saw the S&P Depositary Receipts (SPDR) S&P 500 ETF (SPY) has an annual expense ratio of 0.09%.
What about an ETF that tracks the same index but takes a short position?
As at December 1, 2018 the inverse ETF ProShares Short S&P500 (SH) has an expense ratio of 0.89%.
Once again, a significant price is paid for the more complex fund.
Tracking Error
In using derivatives to short the index, there may not be a perfectly negative correlation.
Or, over time, the ETF may experience return drift as small tracking imperfections magnify. The greater the time frame, the greater the potential deviation.
Both of these can impact the performance of the ETF and not allow it to inversely mirror the index’s returns.
Conclusion
I do not invest in inverse ETFs. But that is mainly because I do not like to pay management fees and am I able to use derivatives and margins to short positions when I wish.
For investors that cannot, or do not want to trade derivatives or personally short securities, it may be worth it to pay a management fee for this service.
When to Potentially Use Inverse ETFs
I would not advise investing in inverse ETFs as a long-term strategy. That would assume the markets will continuously decline in value. Likely not a valid assumption. But if it was, the markets can only fall so far and there would hopefully be other asset classes that would make better long-term investments.
Instead, using inverse ETFs as short-term hedges may be prudent. Locking in investment gains or seeking protection from anticipated declines in specific sectors.
Others may utilize inverse ETFs to engage in market or sector timing activities. Not necessarily a bad strategy but be aware that trying to time market movements is extremely difficult.
Analytical Keys When Selecting an Inverse ETF
In selecting an inverse ETF, analysis should focus on three areas.
One, if the fund is actively managed, what is the experience and track record of the managers? If you plan to pay for professional management, you want to hire the best you can find.
Two, how well does the fund inversely replicate the performance of its benchmark index? If you believe that an index or sector will decline, you want to make sure that the inverse ETF will rise in approximately the same proportion.
Three, what is the fund’s annual expense ratio on both an absolute basis as well as relative to the ETF’s peer group and alternative investments? There may be significant differences between expense ratios on inverse ETFs tracking the same index. Always try to get the best performance for your investment dollar.