Exchange Traded Funds

Who comes up with these names? Couldn’t they be a little bit more creative? Are ETF’s the same as mutual funds?

An Exchange Traded Fund refers to shares of a fund traded on an exchange. The same way stock is traded on an exchange. So, someone rearranged the words and came up with Exchange Traded Funds. An exchange, like the old New York Stock Exchange, is responsible for matching buyers and sellers. Exchange Traded Funds are really a hybrid type of mutual fund.

Exchange Traded Funds or ETF’s are a fairly recent invention in the investment world. The first ETF was issued in 1993.

The first US mutual funds were issued in the 1920’s, before the depression.

ETF’s are often mistaken for mutual funds because they do share some common features .

One feature is that they are both pools of assets. You the investor buy shares of the pooled assets .

Another ETF feature is “passive management” versus an unmanaged index.

An index is also known as a benchmark.

For example, one of the most widely  used indices in equity investing is the Standard and Poor’s 500 index.

Theoretically a passive manager will buy all 500 stocks in the index. Something an individual investor would not do. I say theoretically because there is an ongoing debate about active versus passive investing . The basic assumption is that a passive investment manager  is not making active decisions about what stocks to buy. The reason for passively managing a fund is to replicate the performance of the index.

An active manager would pick individual stocks with the objective of delivering performance returns that are higher than the index.

ETF’s tend to have lower fees than mutual funds. It isn’t always true, but the rational is the higher cost to the investment manager of actively trading a fund. Higher fees are” justified” when the active manager provides higher returns than a passive manager.

ETF’s and mutual funds are not the same in several important areas:

Mutual fund shares are priced once a day after the close of the market. If you want to buy or sell shares of a mutual fund, you place an order without knowing what the closing price will be. The point is that there is one price per day for the buyer and one price per day for the seller. The one price feature dampens the type of price volatility you would expect when buying individual stocks.

Shares of ETF’s trade all day long, just like stocks. You can buy and sell shares of an ETF during regular trading hours. The price of an ETF share is based on a “premium” or “discount” to the actual value of every stock in the fund.

Another way to say this is, ETF shares trade at a price that is either higher or lower than the actual prices of the securities in the fund.

If I lost you there despite my no jargon rule, it is intentional. ETF’s are more complicated than they seem.

Mutual funds tend to be opaque. If you the investor want to torture yourself trying to figure out what securities the mutual fund owns, you have to wait , in some cases, 60 days after the end of a quarter to see the holdings.

The reason this policy was implemented was to prevent investment managers “stealing” ideas from each other. This might have happened in the eighties or nineties but today it seems a bit ridiculous.

The truth is, looking at the holdings of a mutual fund will not give any other investment manager or individual investor any idea of what the strategy is.

ETF’s are transparent. You can see the holdings of an ETF if you are really curious.

Seeing the holdings of an ETF is a feature but not necessarily a benefit .

The reason to see the holdings would be to target a very narrow segment of the market.

If you wanted to invest in a specific currency or commodity you can look for an ETF that buys gold or euros for example.

Transparency alone does not equate to better pricing or better returns to you the investor.

At the beginning of each year we look back and compare how managers performed versus an index.

I have chosen to compare three S&P 500 ETF’s.

BlackRock’s’ S&P 500  ETF is : iShares Core S&P 500 ETF . The ticker symbol is IVV.
State Street ETF’s are called spiders : SPDR S&P 500 ETF . The ticker symbol is SPY.
The Vanguard S&P 500 ETF has the ticker symbol VOO.

A side note, ticker symbols are not random. Many meetings with high priced executives take place to come up with catchy sounding tickers.

IVV –   sounds like Ivy ?
SPY –  who could forget it?VOO – short for Voodoo ?

Now let’s compare the performance in 2018 of the three ETF’s versus the S&P 500 index.

2018	Performance	Difference between Index and ETF
S&P 500 Index	-4.38%
IVV	-4.47%	9 Basis Points
VOO	-4.50%	12 Basis Points
SPY	-4.56%	18 Basis Points

The S&P 500 Index, also known as the “market” index returned negative 4.38%

in 2018.

The reason you want to check this number is to make sure when you look at the performance of your own portfolio you have a point of reference.

It’s important to know that in 2018 the overall market using the S&P 500 index as a gauge was negative.

The next question is ; was my investment more negative or less negative? . You can see above that each of the three ETF’s were slightly more negative than the index.

Anyone invested in the S&P 500 , in 2018, through mutual funds or ETF’s lost money.

But, did the managers of the ETF’s do their job? Yes, they did. The performance returns  numbers were all within a fairly narrow range . Their objective is to come as close as possible to the return of the index.

It is always better to look at longer periods of investment returns than one year but 2018 ended up being a rough year and we have to keep returns in perspective.

Do you own any ETF’s? Check the descriptions of your investments by looking up the ticker symbol.

Should you buy an ETF or a mutual fund?

Two reasons to buy an ETF:

1. You are looking for exposure to a specific sector of the market, like healthcare, or to a specific asset class, like gold.
2. There are no comparable mutual funds.
3. You intend to trade shares of the ETF frequently.

If you are comparing a mutual fund to an ETF always look at the performance Net of Fees or After Fees.

Fees have been reduced dramatically in both mutual funds and ETF’s however remember to start with your allocations to the different asset classes first. Then compare net of fee performance before you choose a fund.

 

 

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.