Why Are ETFs Better?

Exchange Traded Funds, or ETFs, are the most efficient vehicle yet devised to harness the returns of stock and bond indexes. They capture nearly all of the underlying assets’ returns with little or no leaks of taxes, expenses, or under-performance.

Efficiency is one of the most important considerations of investing for lifetime purposes, yet it is almost universally ignored or minimized by an industry that asks us to assume that superior results will compensate for all the extra costs. Unfortunately it rarely works out that way in real life. Costs are guaranteed and persistent, but superior returns ARE NOT.

Exchange Traded Funds offer a host of benefits over alternative investment options like mutual funds, individual stocks and bonds, and managed accounts. We will demonstrate them one-by-one.

Exchange Traded Funds represent undivided interests in large holdings of securities, enabling individual investors to broadly diversified and huge numbers of stocks or bonds. For instance, the Vanguard Total Market ETF holds more than 3,600 company stocks representing more than 99% of the US stock market.

Unlike mutual funds, which grow and shrink as investors buy in or leave their fund, an ETF’s fund is fixed in size. Individual shares representing ownership in the fund are sold to the public when it is launched. These shares can be traded on exchanges for liquidity throughout the trading day. The benefits are several. Investors can buy or sell at very nearly the real-time net asset value of all the stocks and bonds in the fund. Mutual fund investors do not get an exact price when buying or selling. The fund fixes a price at the end of the day when they have tallied up its value given the day’s buys and sells as well as the stocks’ changes in value.

In the mutual fund structure, managers must buy new stocks or bonds in accordance with their portfolio as new investors come into their fund and sell when they leave it. This dynamic poses three distinct problems for their investors. Transactions driven by both investors’ coming and going as well as strategic shifts of their managers generate large transaction costs. When markets are rising, the fund’s gains become diluted as new investors enter the fund. The manager must buy increasingly expensive shares to satisfy demand of new owners. A worse dynamic happens when markets are declining as managers must sell assets to satisfy exiting owners even though they may be confident in a rebound. Finally, all these transactions can generate substantial gains taxes for holders in taxable accounts.

Exchange Traded Funds suffer none of the shortcomings of mutual funds listed above. Because the fund is fixed, transactions are limited only to changes in the index itself. Investor liquidity is provided by shares that trade independently of the funds assets. And they do not trade blindly. At any given time during market hours; both trading and net asset values are knowable. For instance, the Vanguard Total Stock Market ETF as of the writing of this Brief could be sold for $104.84 and the net asset value of all the 3,600 stocks represented at the same time was $104.86 (or a discount of -0.2%).

665-1

You will notice some other interesting facts in the figure as well. The volume of trades after less than an hour of trading is 362,399, nearly 10% of a day’s average trading. This substantial volume provides confidence that the fund has likely settled down in price having satisfied any pent-up demand from the night before. No such price/value guidance is available during the day for mutual funds. You can also know exactly what you own at any given moment in an ETF. With mutual funds, you can only be sure of what the fund owned as of the last quarterly report.

Notice to the far right of the figure above that the VTI’s ‘Expenses’ are 0.05% of assets. The average actively managed mutual fund expense is around 1% of assets. In this case the VTI is 20 times more cost efficient than the average broad stock market mutual fund.

Does 1% really matter that much? Let’s look at an actual couple who is 55 years old, saving about $25,000 annually, with $1.4 million saved so far. Using Monte Carlo we see at the 85th percentile (approaching the worst markets and returns) that our couple will have $1.4 million less money when they are 75 years old if they pay an additional 1% in expenses ($1.2 million vs. $2.6 million). Efficiency matters.

Taxes reduce efficiency as well. The significant number of transactions occurring in mutual funds to adjust for the ins and outs of investors and the strategic changes their managers make all generate taxable gains and losses. According to the Wall Street Journal, some notable funds last year distributed capital gains of as much as 30% of their asset values last year. That  means that taxable holders of these funds were exposed to significant capital gains taxes whether they sold their shares or not. On average, mutual funds’ performance is reduced by 1% when held in taxable accounts. If our couple held these funds in their taxable accounts, amounting to half of their holdings, they would sacrifice an additional $700,000 in portfolio potential in 20 years at the 85th percentile.

What about individual stock investing? Again remember, we are talking about investing for long-term life purposes. There are some very good professional investors out there who do well with individual stocks, whether their own, or for others. But the measure of their success is return-focused rather than confidence-focused. Individual stock investing is more volatile than broadly diversified index-investing. Volatility reduces life-plan confidence, requiring greater performance enhancement just to equal the long-term results of the more stable index. And we know the odds of out-performing indexes for anyone declines over time. Individual stocks for long-term wealth-building is inefficient when greater confidence can be achieved through lower-volatility

Index returns are more persistent than individual stocks. Stocks tend to cycle up and down, while the leadership within the index changes internally pushing the index more consistently forward. When an individual stock manager is motivated to best index returns, as is usually the case, he is motivated to sell under-performers to buy out-performers. The transactional expenses (taxes and trading) add a hurdle he must cross just to equal his benchmark, the index. Add the ever-present threat of his guessing wrong with each buy and sell (65% of managers fall short of index returns over 10-year periods – and the 35% over-performers are not predictable) and the guarantee of efficiently capturing nearly 100% of the index’s return over long investment cycles, by comparison, looks pretty good.

Finally, ETF’s provide an elegant simplicity that increase efficiency in delivering substantial wealth-enhancing measures, like rebalancing, asset location, asset allocation, and tax-loss harvesting. Fewer moving parts means more cost savings as wealth-enhancing processes are performed. When you own one ETF that represents the ENTIRE US stock market, you don’t have to worry about adding gold, real estate, oil, consumer non-durables, or Apple. There all in there. What’s more, you don’t have to worry about keeping your value stocks in balance with your growth stocks or your mid-caps and small-caps from taking over – the ETF or the index self-balances. It’s all in there. Complexity does not justify high fees when a simple portfolio of ETFs gets the job done as well or better.

Exchange Traded Funds are quickly changing the investment industry as they allow individual investors to cut costs and improve efficiency. But all the efficiency in the world does you no good if you fail to aim it in the direction you want to go. Efficiency is important, purpose is vital. Let us help.

Sam Bass
[email protected]conwc.com