ETFs 101 – Part II

In Part I of ETFs 101, we gave a brief intro to ETFs.  In PART II, we will compare ETFs and traditional mutual funds

 Advantages of ETFs over Mutual Funds

ETFs, in my opinion, have many advantages over traditional mutual funds.  Let’s look at a few of these advantages.

1) Cost/Fees

The management expense ratios (MERs) of ETFs are much, much, much lower compared to mutual funds with a similar investment objective.  As shown in the table below, MERs of ETFs are significantly lower than the average fees of actively managed mutual funds or mutual funds that simply track an index like the ETF does.

MERs reduce an investor’s return.  Mutual fund managers attempt to justify the higher cost by trying to beat the index.  However, as pointed out in Part I of this series, it is a difficult task to do so over the long run.

MER Cost Comparison:
CATEGORY AVG ACTIVE     fUND MER AVG INDEX               FUND MER ETF MER ETF NAME
Cdn Fixed Income 1.38% 0.95% 0.30% iShares DEX Universe Bond Index – XBB
Cdn Equity 2.29% 0.95% 0.25% iShares S&P Capped Composite Index – XIC
US Equity 2.30% 0.95% 0.15% Vanguard MSCI US Broad Market Index – VUS
International Equity 2.46% 1.08% 0.46% BMO International Equity Index – ZDM

Sources:
-Investor Economics, Insight Advisory Service, July 2010.
-http://ca.ishares.com/content/stream.jsp?url=/content/en_ca/repository/resource/basics_of_ishares_en.pdf

In addition to the MERs, mutual funds may also have additional fees tacked on when buying or selling the funds (known as front-load or deferred sales charge fees).  This can really put a drag on the investor’s returns.  Funds with front-load fees take a portion of the money initially invested, thus leaving a smaller pool of money that ultimately gets invested.  Fund with deferred sales charges take away a portion of the investor’s money when the fund is sold.  Doesn’t really seem fair, does it?

2) Tax Efficiency

Mutual fund managers can trigger unexpected tax liabilities for the investors.  When fund managers buy and sell stocks in the mutual fund, they may sell stocks that have gone up in value.  As a result, the investor holding the mutual fund will end up with a gain without realizing it, and thus would have to pay taxes.

This situation can also occur with ETFs but it happens to a lesser extent due to lower turnover compared to mutual funds.

3) Transparency

With ETFs, you can find the underlying holdings in the fund everyday, so you know exactly what you have.  Mutual funds do not have to disclose the holdings everyday so you cannot be certain what investments you are holding at any given time.

4) Flexibility

ETFs can be traded any time the stock market is open.  Being able to trade ETFs on the exchange opens up the possibilities for investors to buy/sell them using leverage/margin or short sell them if so desired (not that I recommend doing so).

In addition, some ETFs are ‘optionable’ (ie, you can buy/sell options on them…we’ll save the details for another day).  Being able to trade options on ETFs can open up additional investment strategies that are not possible with mutual funds.

Disadvantages of ETFs versus Mutual Funds

Alright, time to talk about some of the disadvantages of ETFs versus mutual funds.

1) Brokerage Commissions or Trading Costs

Since ETFs are traded like stocks, you need a brokerage account to make trades, which means paying commissions.  Tradings costs are pretty low these days so this should not be a big factor, especially if you are not an active trader.

The Scotia iTrade discount brokerage currently offers commission-free ETF trading on 50 ETFs at the time of writing this article.  I hope more brokerages start offering something similar!  (By the way, I am in no way affiliated with Scotia iTrade, nor do I use their platform so this is not an endorsement.)

Bottom line is, yes there are trading costs, but these costs should be pretty low.

2) Purchase Increments

Since there are trading costs associated with purchasing ETFs, buying them in small amounts doesn’t make sense since the trading cost could end up being a large percentage of the amount you are buying.  For example, if you want to purchase $100 worth of an ETF, but it will cost you $10 to buy and $10 to eventually sell, you’d need the ETF to gain 20% to offset the trading cost alone.

Some ETFs do offer the regular monthly contribution (PACC) plans to allow for small purchases without commissions, similar to what one might be used to with their mutual funds.  However, not all brokerages will allow you to participate (after all, they end up losing commissions).  I’d like to see this hurdle eliminated someday as the industry matures.

3) (Most) ETFs Will Not Outperform The Index

Most ETFs are designed to passively track an index, thus they will never do better than the index.  As pointed out in Part I, most active managers do not outperform their respective index either.

There are the so called Active ETFs available as well.  Whether or not these will do better than the index they are tracking will be interesting to observe over the long run. They might have a shot since the fees are still relatively low.

4) Need For Advice

Unless you are a DIY investor, you will most likely need to pay for someone to set up and manage an ETF portfolio for you.  Even if you have to pay someone up to 1% of your assets as a fee, you can probably keep your total costs to around 1.5% which is still fairly reasonable.

In Part III of this series, we’ll look at some ETFs that may trip up an investor because they may not behave as one expects.

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