ETFs: The End of Traditional Mutual Funds?

A relative new comer to the investment world is the Exchange Traded Fund (ETF). You can think of it as a cross between individual stocks and mutual funds, with a mixture of advantages and disadvantages of each. An ETF trades on a stock exchange like a stock but the underlying investment holds stocks and bonds similar to a mutual fund. Like stocks, when you buy and sell an ETF you generally pay a commission. Since the underlying securities are not being traded there are potential tax efficiencies from avoiding capital gain distributions and minimizing management fees.

Before 2008 when the U.S. Securities and Exchange Commission authorized the creation of actively-managed ETFs, all U.S. ETFs tracked an index. It is not surprising that the older ETFs track the most popular indexes such as:

• S&P 500 Depositary Receipt (SPY) tracks the S&P 500 Index
• Vanguard Total Stock Market ETF (VTI) tracked Dow Jones Wilshire 5000 Composite Index through April 22, 2005, and performance of the MSCI US Broad Market Index thereafter.

Given the efficiencies of ETFs there has been a great deal of interest in them. Despite 2008’s market crash, there were 160 new exchange-traded funds launched with net inflows into U.S. equity exchange-traded funds of $120.8 billion. ETFs are gaining market share at the expense of mutual funds. In 2008, there were only 21 new mutual funds and U.S. equity mutual funds saw a $162.4 billion net outflow. Many mutual fund companies have seen the writing on the wall and have decided that if you can’t beat them, join them.

At the time of this writing, Vanguard offerd 38 ETFs covering just about every conceivable sector and niche. Here are several random samples:

• Long-Term Bond ETF (BLV) tracks Lehman Brothers Mutual Fund Long Government/Corporate Index
• Dividend Appreciation ETF (VIG) tracks the Dividend Achievers Select Index
• REIT ETF (VNQ) tracks Morgan Stanley REIT Index
• FTSE All World ex US (VEU) tracks the FTSE/(R)/ All-World ex USA Index

ETFs can be used to fill a void where you either don’t have the expertise or the time needed to pick individual stocks, such as international dividend investing. Like any other index, an ETF will likely hold securities that you would not buy otherwise.

Full Disclosure: Long VTI, BLV, VIG, VNQ

References
- Forbes: Attack Of The ETFs
- Wikipedia: Exchange-traded fund
- SEC: Exchange-Traded Funds (ETFs)

Comments

[Mad Hedge F...:]

This will be a big grower this year. This could be the year of the Exchange Traded Fund (ETF), which was one of the few growth products in an otherwise disastrous year for the brokerage community. Asset allocators are attracted by the ability to make single sector bets, like in oil (USO), leveraged short plays that would otherwise be banned, like the 200% short long Treasuries fund (TBT), intraday trading, and low fees. The only thing missing is liquidity, which is still inadequate in all but a few of the biggest ETF’s. There is now thought to be $400-$500 billion invested in these funds, compared to $4 trillion plus in mutual funds, and the rate of innovation is accelerating. The early entrants in the field, like Vanguard and Barclays Bank, are raking in the cash, leaving more conservative families of funds like Fidelity in the dust. Expect to start seeing more ETF’s in your 401K’s and pension holdings.

Apr 03 11:21 AM

[Lightway:]

Awesome, I was hoping you would start covering some dividend ETF's. I use them to round out my income portfolio, mostly when allocating out my bond exposure. I'm really happy with many of the bond ETF choices out there, especially their low fees and good income returns.

My previous hesitancy with using ETFs was the transaction fee per share purchase, which makes them costly if you are investing long over time, but using Folio has eliminated that entirely. ETFs used to be viewed as renegade day trading vehicles, but they are getting alot of respect recently as long term income generators.

I am echoing the sentiments of many of the readers here who are down on mutual funds versus ETFs. I am still holding on to some Pimco bond funds, and a couple of equity funds, but I'll be cashing out my equity funds at the peak of the next bubble and exchanging them for ETFs.


Mad Hedge Fund Trader,

I hope that our 401K starts giving us some ETF options. I am really unhappy with many of the choices we are offered. Ours is administered by Fidelty, which seems to be falling behind the times with their offerings. It seems more geared towards Modern Portfolio Theory, which worked well in 1998, and I still use it (only for 401K since that's all we have to choose from), but I'd like to see what I call "Modern Portfolio Theory PLUS" type offerings in 401K, which gives exposure to asset classes outside of stocks and bonds.

Apr 03 06:03 PM

[AndrewBaker:]

ETF are very useful and becoming much more varied in the investment choices that may be made. In addition, any-time (when the markets are open and pre and post market trading hours) dealing is extremely useful. Mutual funds have got a big rival here.

Apr 04 08:45 AM

[Dotcom:]

I've had a problem dealing in pre & post index ETFs i.e. my trade doesn't get executed until the market is open resllting in me not getting the pre market price. I use Vanguard. Any ideas?

Apr 04 12:27 PM

[Chancer:]

Statistics show that private pension funds, which can invest anywhere, perform twice as good as 401k's which usually only allow investments in one fund family or the (usually worse) offerings of an insurance company adminstrator. Over the long haul, this is harming retirement investments.

However, for individual IRA's and those rolled over from 401k's mutual funds are easier investments than ETFs which probably require you to hold your IRA in a broker's account (at least for now).

This mess is what happens when you have politicians and IRS bureaucrats making up the rules for retirement investing.

And the public wants to give health care to the government, beacuse they have done a great job at everything else. The post office is closing on Saturdays. The government will make your GM hybrid car. Will you get a car that does not run on Saturday?


On Apr 03 06:03 PM Lightway wrote:

> Awesome, I was hoping you would start covering some dividend ETF's.
> I use them to round out my income portfolio, mostly when allocating
> out my bond exposure. I'm really happy with many of the bond ETF
> choices out there, especially their low fees and good income returns.
>
>
> My previous hesitancy with using ETFs was the transaction fee per
> share purchase, which makes them costly if you are investing long
> over time, but using Folio has eliminated that entirely. ETFs used
> to be viewed as renegade day trading vehicles, but they are getting
> alot of respect recently as long term income generators.
>
> I am echoing the sentiments of many of the readers here who are down
> on mutual funds versus ETFs. I am still holding on to some Pimco
> bond funds, and a couple of equity funds, but I'll be cashing out
> my equity funds at the peak of the next bubble and exchanging them
> for ETFs.
>
>
> Mad Hedge Fund Trader,
>
> I hope that our 401K starts giving us some ETF options. I am really
> unhappy with many of the choices we are offered. Ours is administered
> by Fidelty, which seems to be falling behind the times with their
> offerings. It seems more geared towards Modern Portfolio Theory,
> which worked well in 1998, and I still use it (only for 401K since
> that's all we have to choose from), but I'd like to see what I call
> "Modern Portfolio Theory PLUS" type offerings in 401K, which gives
> exposure to asset classes outside of stocks and bonds.

Apr 04 12:43 PM

[BigOlDave:]

Q: ETFs: The End of Traditional Mutual Funds?

A: Yes.

Apr 04 05:25 PM

[Fund Insider:]

While ETFs are a great alternative, the concept is not really new.
They are very similar to closed end funds, which trade on the exchanges like ETFs, hold a basket of securities like ETFs.
There are some technical differences, including ability to issue more shares (easy in ETF, not common in CEFs but CEF issuers just open yet another CEF if there is sufficient interest unmet).
ETFs are great for index investors and CEFs for those who want active management. CEFs do not disclose holdings continuously like ETFs, and that's the only way an active manager would have it.

As far as the death of open end funds, CEFs have been around longer than open end funds, and it was just the opposite. open end funds almost killed CEFs, but CEFs are still here, and so will open end funds. The main difference between now and years ago is that commissions are lower so the cost of trading ETF/CEFs is lower, making it competitive with open end funds in transaction costs. Also easier for a fund manger to open a new open end fund than a new ETF or CEF, hence the relatively small # of CEFs vs OEFs historically. ETFs don't change that. The other problem with CEFs/ETFs is that fact that you need a brokerage account. Once you have a brokerage acct trading CEFs/ETFs, you can also trade individual stocks. Regulators have always treated brokerage accounts with more restrictions and governance than open end funds. You don't see "self directed" 401K or 529 plans do you ?
Then no, you wont see ETFs or CEFs in those either, unless brokerage firms come up with some new type of account that can only trade funds and no individual securites, and regulators accept that as "safe" for the little guy, and believe it avoids the potential
for insider trading/market manipulation (as with individual stocks).

Apr 06 09:26 AM

[Husker Mike:]

ETF's are great tools when you are dealing with lump sums, where you can spread the commission or service charge over a large investment. They still are inferior to standard mutual funds when dealing with smaller amount investments, such as with a monthly investments to an IRA, where the commissions and fees can eat you alive.

Each tool (ETF and standard mutual fund) has it's place.

Apr 07 02:30 PM

[donzelion:]

For index funds v. index ETFs, the winner depends on the total costs. ETFs usually win on management fees, while index funds win on transaction fees. Seems the best strategy right now utilizes both: "parking" funds in an index fund, then moving big blocks over to an index ETF periodically.

However, ETFs can be a poor choice when one lacks information because they tend to create a prima facie similarity among very different markets. People have always lacked basic information about emerging markets (that's sort of a precondition for being "emerging" as opposed to "developed") - so an index appropriate to a developed market will only be appropriate to emerging markets IF the facial similarities are actually real. That's not an assumption I'm willing to bet my retirement on (particularly since my day job consists of trying to correct the results of people who mistakenly make that assumption).

Apr 20 05:59 AM