Investments in U.S. Exchange Traded Funds (ETFs) have grown far quicker than mutual funds over the past decade and now hold approximately $2.22 trillion in assets. Retail and institutional investors alike have poured into ETFs in recent years, lured by the promise of low costs, enhanced tax efficiency and unmatched trading flexibility.
While it is undeniable that ETF fund issuers have managed to provide investors with benefits, they have also proven adept at marketing ETF offerings. In order to balance the ledger, here are eight things you should know when you buy an ETF.
1.Trading Costs on ETFs are not insignificant. Normally investors will incur a commission when purchasing an ETF in addition to paying the inescapable bid/ask spread, which is essentially the amount by which the ask price exceeds the bid price. Currently in the ETF universe the asset weighted bid/ask spread is 0.07% (higher than a lot of expense ratios!).
2. Dividend Reinvestment is generally more efficient in mutual funds than in ETFs. On average, ETFs take two or three days longer than mutual funds to reinvest dividends, which can result in a significant performance drag. An investor may also incur bid/ask costs again upon the reinvestment of dividends. Why "may"? Becuase it depends on your brokerage terms.
3.Premium or Discount Costs arise when trading ETFs because the market price for an ETF deviates around its net asset value. If you purchase a mutual fund you will always buy it at net asset value. This is not the case for ETFs.
4.ETFs have experienced temporary periods of extreme mispricing. In the past, market volatility, bouts of illiquidity in underlying securities and trading halts have all caused scenarios where ETFs have traded tens of percentage points away from net asset value.
5. Securities Lending is a common practice amongst ETFs and in some cases ETF fund issuers take a sizable portion of securities lending profits for themselves. As an investor you are likely to bear all of the risk associated with this activity and yet won’t necessarily receive all of the return.
6. Sampling or Optimization strategies are utilized by most ETFs in order to more efficiently track an index. This can often lead to better performance for investors, however, it is worth knowing if 20% of your money in a U.S Large Cap ETF is invested in non-index positions.
7. Average ETF Turnover is approximately 870% and 4 times greater than the average turnover of U.S. Stocks. One of the largest ETFs, SPY, has an annualized turnover rate of 3400%. Many ETFs are utilized by hedge funds and other short term speculators to jump in and out of the market on a daily basis.
8. Check the index. Some indexes have lower licensing fees than others so the cost to the ETF provider will be lower. But some indexes are better than others. The S&P 600 (SML), a small cap index, has outperformed the cheaper Russell 2000 (RUT) small cap index very significantly over many time periods
All ETFs are not the same and some may prove to be more expensive and expose investors to greater risk than others.
We appreciate the flexibility of ETFs and use them in our client accounts. But we believe extensive research is necessary when comparing ETFs to one another and mutual funds.
- Christian Thwaites & Curtis McLeod
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.