10 Common Myths About ETF Investing

|
 |  Includes: AGG, CWI, EEM, GLD, IVV, PIQ, PIZ, PWC, QQQ, RYJ, SPY, USO, VIG, XLE
by: Michael Johnston

Boasting competitive cost structures, enhanced tax efficiencies, and improved liquidity features, ETFs have quickly become one of the most popular tools for all types of investors. But despite the rapid rise of the industry over the last five years, there are still countless investors, including many financial advisors, who are completely unaware of exchange-traded funds. Even among those who are relatively well educated on the basics of ETFs, confusion on the nuances of these products can run rampant.

While the benefits and functions of ETFs are relatively simple to grasp, there are some complexities that have created confusion about these products. Below are a look at ten of the most common myths about ETF investing, along with some simple (and not-so-simple) truths.

Myth #1: ETFs Eliminate Investor Tax Liabilities

When touting the benefits of exchange-traded products, most investors lead with the reduced cost structure and enhanced tax efficiency relative to actively-managed mutual funds. While the lower costs associated with ETFs is relatively easy to explain and understand, the tax advantages are a little more difficult to grasp. Many investors mistakenly believe that ETFs are taxable at a lower rate than stocks or mutual funds, or that ETFs are exempt from taxes altogether.

The tax efficiencies of ETFs are primarily related to the creation/redemption process: because investors trade with each other, managers don’t have to sell off assets whenever investors want to cash out. Moreover, savvy managers can use the in-kind redemption process to slough off shares that have the biggest unrealized gains, thereby limiting taxes that will ultimately be paid.

But ETFs are not immune to capital gains distributions for example – they may make them if the underlying benchmark changes or one company in the index acquires another. And gains incurred on ETFs will, under most circumstances, still be taxable to individual investors. The tax benefits of ETFs are very real, and can have a material impact on bottom-line portfolio performance. But ETFs aren’t a magic cure-all that will keep the tax man at bay indefinitely.

Myth #2: ETFs Are Primarily Used By Long-Term, Buy-And-Holders

Due to their ultra-low expense ratios, ETFs would seem to be the ideal tool for long-term buy-and-hold investors looking to enjoy the benefits of compounding returns while avoiding what Jack Bogle calls the “tyranny of compounded costs.”

So investors may be shocked to see the turnover numbers exhibited by some of the funds that are generally found among the “core” holdings in many investor portfolios. As shown in the table below, many broad market and sector-specific ETFs exhibit daily trading volumes that imply a turnover period measured in weeks, not years. The Energy Select Sector SPDR (NYSEARCA:XLE), for example, has a daily volume equal to about 20% of total shares outstanding, indicating that the fund turns over every 5 trading days.

ETF Avg. Volume Shares Outstanding Daily Turnover
iShares S&P 500 Index Fund (NYSEARCA:IVV) 4.2 million 192.8 million 2.2%
iShares Emerging Markets Index Fund (NYSEARCA:EEM) 85.9 million 902.7 million 9.5%
SPDR Gold Trust (NYSEARCA:GLD) 17.7 million 350.0 million 5.1%
PowerShares QQQ Trust (QQQQ) 99.7 million 399.6 million 24.9%
Energy Select Sector SPDR (XLE) 21.5 million 106.9 million 20.1%
Click to enlarge

So it is clear that a significant amount of the money in ETFs is not in low-activity retirement accounts, but rather in the hands of more active traders. This shouldn’t be all that surprising considering the depth of exposure offered by ETFs. After all, the wrong stock in the right sector still yields a negative result. ETFs offer a way for active traders to place bets on trends they see developing without taking on significant company-specific risk (indicating that perhaps ETFs are competing more with individual stocks than they are with mutual funds).

Myth #3 ETFs Are For Short-Term Investors Only

Those who interpret daily trading volume reports as an indication that short-term traders have embraced exchange-traded funds may swing to the opposite end of the spectrum, believing that perhaps ETFs should be avoided by investors with a long-term focus. If sophisticated, high-volume traders are the primary users of ETFs, some liken investing in these funds to being thrown into the shark tank – along with the sharks.

Lamenting that ETFs have become so popular among day-traders, legendary investors and industry pioneer Jack Bogle has expressed that the ETF is a truly great business model that has been transformed into a flawed investment model. His point is that ETFs were designed for buy-and-holders and have the potential to perform very well when used to achieve long-term investment goals.

Don’t be scared off by the notion of going up against sophisticated day traders in the ETF market. The creation / redemption process ensures that prices won’t deviate too significantly from NAV and the long term benefits of using ETFs are very real…which leads us to the next myth:

Myth #4: For Most Investors, ETF Savings Don’t Add Up

It’s often said that football is a game of inches. Well, investing is a game of basis points, and for those investors who are in it for the long haul (i.e., anyone with a retirement portfolio) a few basis points here and there can make a big difference. Our All-ETF Model Portfolios ETFdb Pro Members Only include several strategies that offer weighted-average expense ratios of 20 basis points or lower. (Read more here).

Over an extended period of time (say 30 years), the bottom line impact of paying 20 basis points per year (again, we have developed several portfolios that come in at or below this level) as opposed to 100 basis points (a conservative estimate for actively-managed mutual funds) can be material. The following table shows the hypothetical growth of an initial $1 million investment under these two scenarios.

Growth of $1 Million Over 30 Years @ Annual Return Of:
Portfolio Expense Ratio 5% 10% 15%
All-ETF Portfolio 0.20% $4,081,676 $16,522,289 $62,842,961
Actively-Managed Mutual Fund Portfolio 1.00% $3,243,398 $13,267,678 $50,950,159
Click to enlarge

The impact over a single year may be negligible, but when compounded over a longer horizon, the savings generated by ETFs definitely add up.

Myth #5: Investors Should Always Avoid Leveraged ETFs

Five Leveraged ETF Myths
Don’t Perform As They Claim They Will
Are Too Complex For Most Investors To Understand
Always Erode Returns When Held For Multiple Days
Target Retail Investors
Misuse By Uninformed Investors Is Rampant
Click to enlarge

Much of the media coverage on the ETF industry has been flattering – reduced fees and enhanced liquidity are an easy story to sell – but there have been some rather harsh criticisms as well. Most of the negative publicity has focused (rather unfairly) on leveraged ETFs, products that are designed to deliver amplified daily returns (both positive and negative) on various benchmarks.

Leveraged ETFs generally do a very good job of accomplishing their stated objectives (leveraged daily returns), but have been dragged through the mud because they don’t deliver the returns that some expect of them (point-to-point leveraged returns). A unique consequence of the recent financial crisis also led many investors to incorrectly conclude that leveraged ETFs are flawed products. Because of the extreme volatility exhibited by equity markets in 2008, many funds that compound returns daily saw significant return erosion when held for extended periods of time. But volatility has since subsided, and many investors have learned that the compounding effects of leveraged ETFs can (and often do) work for them.

Make no mistake: leveraged ETFs aren’t for everyone. Double and triple leverage is too much risk for most investors. But for those with an appetite for risk, these funds can be extremely powerful tools that can serve a number of purposes, including amplifying returns (as well as losses) and establishing hedges.

For more on the misconceptions about leveraged ETFs, see this feature.

Myth #6: Commodity ETFs Track Spot Prices

Perhaps more than any other asset class, interest in commodities has surged with the rise of the ETF industry. Once reserved for large institutions, commodities have now become a popular asset class among all levels of investors, with dozens of exchange-traded products offering exposure to everything from crude oil to aluminum to livestock.

Some investors mistakenly believe that the performance of commodity ETPs will move in lock step with spot prices of that natural resource. While some funds (such as GLD) actually hold the underlying, the physical properties of most commodities makes physical storage by these funds impractical (natural gas is a good example).

So most commodity funds invest not in physical commodities, but in exchange-traded futures contracts based on the underlying commodity. In order to avoid taking physical delivery, these funds will generally “roll” the futures contracts as they approach expiration, selling near month contracts and buying second month contracts. While a futures-based strategy will generally deliver returns that are correlated with spot prices, the performance in certain environments can deviate significantly (see this article for a more in-depth explanation).

The United States Oil Fund (NYSEARCA:USO), which invests in crude oil futures is a good example of the issues potentially facing investors. As crude oil prices have jumped this year, a futures-based investment strategy has lagged behind the hypothetical return on spot prices.

USO Spot

The fact that commodity funds don’t invest directly in commodities doesn’t make them flawed products and certainly doesn’t mean that they should be avoided. But investors should understand exactly what they’re getting into (a futures-based strategy) and what they aren’t (direct exposure to spot commodity prices).

Myth #7: ETFs Precisely Replicate Underlying Indexes

ETFs have become popular among investors frustrating with paying active managers to attempt to beat a benchmark when they can simply “own the benchmark” at a significantly reduced rate. Many of the exchange-traded products available to U.S. investors engage in a full replication strategy, holding each security composing the underlying index in the same (or very similar) percentages as the benchmark. The S&P 500 SPDR (NYSEARCA:SPY), for example, holds 500 stocks, each component of the S&P 500.

But there are also several ETFs that don’t “own the benchmark,” including many that don’t even come close. Many of the most popular indexes weren’t designed with the thought of exact replication by investors in mind. ETFs that offer significant depth of exposure (i.e., are composed of thousands of individual securities) may be difficult and expensive for ETF managers to replicate exactly. So these funds use a “sampling” strategy instead, attempting to construct a basket of securities that will match key metrics of the entire index without holding every single stock or bond.

ETF Index ETF Holdings Index Holdings % Held By ETF
Emerging Markets Index Fund (EEM) MSCI Emerging Markets Index 407 751 54%
Barclays Aggregate Bond Fund (NYSEARCA:AGG) Barclays Capital U.S. Aggregate Bond Index 267 8,492 3%
MSCI ACWI ex-U.S. ETF (NYSEARCA:CWI) MSCI ACWI ex USA Index 610 1,812 34%
Click to enlarge

While these replication strategies are generally quite effective, on occasion performance gaps between ETFs and their related indexes can arise. Investors looking to avoid this can look towards more “ETF-friendly” benchmarks that have fewer holdings.

Myth #8: The Liquidity Features of ETFs Make Limit Orders Unnecessary

One of the appealing features of ETFs compared to actively-managed mutual funds is the intraday liquidity, allowing these products to trade like stocks on major exchanges whenever markets are open. Moreover, the presence of Authorized Participants in the creation/redemption process offers up another source of liquidity. But this doesn’t mean that ETF investors are assured of a continuous market for every fund. In fact, there are dozens of ETFs with daily volumes of less than 10,000 shares that may present liquidity problems, especially for those looking to execute large trades.

Even among the largest ETFs, investors may run into liquidity issues. The Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), for example, has a market capitalization of almost $1.7 billion but average daily volume of about 275,000 shares. We’ve heard far too many stories of investors placing a relatively small market order only to see it filled at a wide range of prices, many of which are considerably higher than the indicated bid. When the bid comes down shortly after completion of the transaction, investors find themselves in an immediate hole.

Limit orders are an extremely powerful tool, and should be used in almost every ETF trading situation.

Myth #9: ETFs Will Soon Replace Mutual Funds

I always get a kick out of studies predicting the date at which ETF assets will top mutual funds. The honest truth (coming from someone who eats, drinks, and sleeps ETFs) is that ETFs will never knock mutual funds from their perch atop the investment universe. You and I both know that ETFs are the future, and that the market will continue to expand as more and more investors embrace indexing strategies generally and exchange-traded products specifically. But it’s not going to happen overnight.

The obstacles facing ETFs are both numerous and daunting. Breaking into 401(k) plans seems like a foregone conclusion to many ETF advocates, but the associated challenges will ensure that if this does happen, it will be a very slow process.

There’s another part to this equation: while an increasing number of investors have shunned active management, this strategy will always have its advocates. And for good reason – there are, after all, some fund managers who consistently beat their benchmark and justify the incremental costs to their investors.

The final factor to consider relates to myth #2 on our list. ETFs are used perhaps more frequently as a substitute for individual stocks than as a replacement for mutual funds. The target markets for these products may not have as much overlap as many would imagine. ETFs will continue to gain in popularity and asset size, but mutual funds will be the dominant player in the investment industry for some time to come.

Myth #10: Active Management And ETFs Are Incompatible

Sampling Of “Intelligent” ETFs
Ticker Related Index
PIZ Dorsey Wright Developed Markets Technical Leaders Index
PIQ Top 200 Dynamic Intellidex Index
PWC Dynamic Market Intellidex Index
RYJ Raymond James SB-1 Equity Index
Click to enlarge

Many analysts have pointed to the rise of the ETF industry as evidence that active management has been given a death sentence. While many of the first ETFs (and many of the most popular ETFs) are related to traditional cap-weighted benchmarks, there are dozens of ETFs that blur the line between active and passive management, tracking “intelligent” benchmarks that attempt to employ quantitative analysis to select components poised for outperformance.

The ETF is a great delivery vehicle that wasn’t being fully utilized by the first generation of exchange-traded funds,

says Ed McRedmond Senior Vice President of Portfolio Strategies at Invesco PowerShares.

For those investors who believe in active management, why wouldn’t they want it delivered through an efficient investment vehicle?

But the applications of active management go far beyond actively-managed ETFs. A number of academic studies have shown that the bulk of investor returns are attributable to asset class selection, a task not attempted by most exchange-traded products. ETFs are becoming a popular tool for active managers who seek to generate alpha not through individual stock selection, but through tilting portfolios towards and away from various asset classes, sectors, and maturities depending on macroeconomic trends and conditions.