Dear friends,
As you know, I hold ETFs in the same regard as I hold, say, tasers in the hands of toddlers. Charles is, I know, far more hopeful of their potential for good. It might be selective perception on my part, but it seems as if there have been many more skeptical essays about them since the Monday crash than I'd seen before.
One argument that the term "passive investing" is a marketing fraud. John Rekenthaler does a nice job of pointing out that "passive/active" is not a simple split. There's a spectrum from truly passive (a cap-weighted broad market index) through covertly actively ("smart beta" and rules-governed active ETFs) toward more active (most "active" funds) to most active. I believe that even John's "passive" category
is "active but lethargic." The S&P 500 is an actively managed quant fund whose the managers are employed by Standard & Poor's. They decide who gets in based on a combination of arbitrary rules, from market-weighting to float, profitably and market cap criteria. As a simple example, Avon was booted after 50 years. Why? Market cap was too small. It was then replaced by Hanes. The minimum cap is $4.5 billion, Avon was $3.2 billion, Hanes was $13 billion. So Hanes, a large and profitable firm, has been sidelined for years waiting for another firm in its industry sector to shrivel and get ejected. If Hanes was more representative of the market, should it have been added years ago? Maybe, but the rules say ... Should Berkshire Hathaway, excluded until 2010, have been added decades ago? Maybe, but the rules say ...
The prime arguments against ETFs seem to be:
1. their cost advantage is illusory. The fact that some ETFs are spectacularly cheap leads investors to assume that all are, which reduces their vigilance as they select investments.
2. they are structurally flawed. The uncoupling on market price from NAV during the crash was one signal of that. A recent article on hedge funds' strategies for gaming the ETF market is another.
3. they structurally encourage bad investor behavior. I smile whenever I read advocates list ETF's "advantages," one of which is always "easy to trade, like a stock." Uhhh ... right, but trading is
bad for everyone except those who make money executing your trade.
I read two interesting essays this morning that add a bit of useful evidence to the discussion.
The Hidden Costs of Commission-Free ETFs lays out the costs of getting on platforms like Schwab and into their NTF programs. Schwab charges ETF advisers an $250,000 "shelf fee" plus 40 basis points to participate in the program. As a result, NTF funds including commission-free ETFs end up charging higher expenses. For every $1,000 you invest, you end up paying $2.20 more in annual expense for commission-free ETFs than for commissioned ones. If the commission is $9/trade, the break-even point is about $4,000 for a fund/ETF held one year; that is, if you intend to invest more than $4,000 and hold it for more than one year, you lose money with C.F. ETFs.
Most absurd ETF trade of all argues that about one-quarter of ETFs charge, before commissions, as much as or more than the average active mutual fund. Some of the data struck me as interesting, though the conclusion didn't. It strikes me as silly to compare ETFs with niche missions (that's typical of the high cost ones) against mutual funds with non-niche missions. Still, the cost warning seems worth it.
For what interest that holds,
David
Comments
A couple of smaller downsides of ETFs:
4. Non-commission trading costs - the bid/ask spread and the (petty) SEC Section 31 fee (currently 0.184 basis points, usually passed through to investors by brokerages).
5. Tracking error - this is the "mini" version of your #2 - structural pricing issues. Even when the market isn't in free fall, there is a divergence between NAV and trading price, due in part to liquidity costs (and I guess also due to the fees that authorized participants pay to the sponsor to buy and sell creation units). This is different from the tracking error of the fund with respect to its benchmark index, which is inherent in all index funds.
On the plus side, ETFs may be more tax-efficient than their OEF counterparts. Only "maybe" for a couple of reasons. One is that well run cap weighted index funds rarely distribute capital gains, regardless of the funds' structure. The other is that Vanguard OEFs share the same advantage as their sibling ETFs, because they are merely different share classes of the same portfolios, not clones.
I completely agree with you regarding S&P indexes (not so for Russell, Wilshire, FTSE). This has been obvious since 2000, when S&P methodically swapped out "old economy" stocks for "new economy" stocks, just in time to see its index (supposedly a measure of market performance) underperform the market by several percent.
http://www.thestreet.com/story/10029393/1/the-sp-500-is-a-mutual-fund--and-a-bad-one-at-that.html
Finally, a note on the CNBC link - Usually, when an article is written saying how wonderfully cheap ETFs are, it gives an "average" equity OEF ER of somewhere around 1.3%. That's an unweighted average and a rather silly figure. Since the purpose of this article is to show how expensive (some) ETFs are, it did the opposite, and gave the dollar weighted average ER of 0.70%. A much better figure IMHO, but without labeling, it seems chosen more to support the thesis than to be objective. (Since no one really cares what numbers mean, let's just pick the "best" one for our point.)
You noted: "The main reason I don't like ETFs is that they require a sizable investment all at once"
Which etf requires a sizable investment beyond the price of the etf "share" at the time of purchase? In effect, one may purchase 1 share, yes?
Thanks.
Catch
I don't advocate buying a share of an etf. But, if one is considering a purchase of "x" $'s into their choice of investment, the $7.95 is a one time event. Obviously, purchasing in chunks would be a whole different consideration. Fidelity does offer a fair number of etf's via I-shares without purchase fees.
Our house tends to move large enough positions that the one time fee, if it applies; to purchase an etf is not a concern. ITOT is a good example if one wants a U.S. equity postion that is somewhat mixed with cap. size. The e.r. is .07%.
Have a pleasant remainder of the evening.
Catch
Indeed, if you compare the ETF and OEM versions of Vanguard funds (say VIG vs. VDAIX) the ETF generally outperforms slightly.
#3, poor market timing, is a danger for all investments.
And mutual funds have plenty of disadvantages too, including hidden fees, trading expenses, taxes, and being forced by skittish investors to buy and sell at exactly the wrong time.
But I'd stay far away from any ETFs that aren't very liquid and cheap.
With VDADX, you get exactly what you pay for (NAV). With the VIG ETF you may get more or less, and that difference varies from moment to moment and day to day (#5). Vanguard shows that as of now (market close, Oct 6) the ETF was trading at a $0.04 discount, so selling near day end would have netted you a few cents under NAV.
Actually, you likely would have lost another penny, because Vanguard (like most providers) gives the closing price of the ETF as the midpoint between bid and ask. VIG typically has a 2c spread, and depending on the Vanguard ETF, the typical spread can be as high as 0.20%. (#4).
Hidden expenses, Vanguard? Trading expenses - these are the same for VIG and its open end siblings, because they share the same underlying portfolio. Likewise any volatility due to skittish investors (again one must ask, Vanguard?) would impact the NAV of the ETF share the same as it would affect the open end class' NAVs.
This is why I feel Vanguard provides the perfect way to compare the two ways of buying/selling shares of a portfolio - ETFs and open end funds. Take the portfolio itself out of the equation and all that's left are the intrinsic differences in sales mechanisms. One always gives you a buck for a buck (NAV), the other often doesn't quite get there, for various reasons.