ETFs Better Than Mutual Funds For Long-Term Investors

Sunday, June 13th, 2010

This article is a guest contribution by Matt Hougan, IndexUniverse.com.

John Bogle is wrong: Exchange-traded funds are actually the best available tool for long-term investors. Better, by far, than mutual funds.

I had this realization the other day when I was speaking about ETFs at a symposium organized by Vanguard. Anytime I put Vanguard and ETFs together, I’m reminded of the fact that Bogle, Vanguard’s founder, dislikes ETFs with a passion rarely seen in the indexing community.

A year ago, Bogle presented data at our annual Journal of Indexes board meeting showing that the average dollar invested in ETFs dramatically underperformed the ETF itself. In other words, investors had a tendency to buy high and sell low.

Bogle’s argument was built on imprecise data, but I’m not going to reopen that. For purposes of this blog, I’m less concerned with the experience of the average investor than the experience of investors who use ETFs correctly. And for those investors, there’s no question: ETFs aren’t just equivalent to mutual funds, they’re qualitatively better.

Usually, when people make this argument, they focus on the fact that ETFs are, by and large, cheaper than mutual funds. While true in general, it’s almost irrelevant. Some institutional mutual funds have lower expense ratios than any ETF. Also, ETF investors bear additional costs in terms of commissions and bid/ask spreads, which mutual fund investors don’t pay.

On costs alone, it’s a tossup.

Where ETFs truly excel—where they are definitively superior to mutual funds—is on fairness.

When you buy a mutual fund, you’re exposed to the actions of others. For instance, if you buy shares in the Growth Fund of America, and then half of the investors in the fund decide to redeem out of their positions, you will bear the brunt of the trading costs as the fund sells stocks to meet those redemptions. If any capital gains are incurred, you will pay those gains, even though you didn’t sell a share and had no intention of exiting your position.

If, on the other hand, no one sells, but another $10 billion in investor cash comes into the fund, you have to pay your share of the costs of putting that money to work: the commissions, the trading spreads, the market impact, etc.

With ETFs, the only thing that matters is you. Outside of a small number of bond funds and a few alternative asset products—such as Vanguard’s ETFs, which share classes of broader mutual funds— existing investors are completely shielded from the actions of others either entering or exiting the ETF. No paying for other people’s commissions, no paying for other people’s market impact and, by and large, no capital-gains distributions driven by the actions of others.

Your investment return and tax profile are driven by your actions, and that’s it.

This may seem like a minor detail, but if you’re investing for 10 or 20 years, those details add up.

I understand Bogle’s concerns about ETFs. Too many people trade them way too often, racking up big costs and they often shoot themselves in the foot trying to time the market.

But the beauty of the ETF structure is that if you’re a long-term investor, none of that matters. It’s just noise.

For the long-term investor, ETFs are the fairer investment, and they should generally deliver stronger after-tax returns.

The low, low costs don’t hurt either.

Copyright (c) IndexUniverse.com

Tags: Board Meeting, Brunt, Capital Gains, Commissions, ETF, ETFs, Exchange Traded Funds, Expense Ratios, Fairness, Hougan, Imprecise Data, Indexes, Indexuniverse, Institutional Mutual Funds, John Bogle, Mutual Fund Investors, Realization, Redemptions, T Pay, Term Investors, Vanguard
Posted in Bonds, ETFs, Markets | Comments Off

ETFs and the “Flash Crash”

Sunday, May 23rd, 2010

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By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors.

Liquidity is one of the key selling points for exchange-traded funds (ETFs), but the Dow Jones “flash crash” of May 6 shows how that supposed advantage can turn into a huge liability for investors.

A report this week from the SEC and the Commodities Futures Trading Commission (CFTC) found that ETFs accounted for the overwhelming majority of securities that fell at least 60 percent that day. Many of those ETFs fell all the way to $0.01 per share during trading.

The SEC-CFTC report blames a lack of liquidity for the crash. Many registered investment advisors, brokers and institutional investors use ETFs in their hedging strategies, but this backfired when a spike in volatility caused a stampede of sellers that crushed prices.

I don’t believe ETFs caused the “flash crash” but the events of May 6 give investors a good reason to look closely under the hood of ETFs. When they do, they might be surprised by what they find.

Research shows that the tradability of ETFs can actually be a costly curse in terms of real returns.

The chart above from MoneyWatch.com shows investor returns minus fund returns for both index mutual funds and ETFs in each available Morningstar “style box” for the five years ending June 2009. Negative figures mean investors lagged the mutual fund or ETF’s return by buying at the wrong time and vice-versa for a positive return.

For example, the average small-cap value ETF investor achieved a return 4.3 percent below what the ETF returned over the same time period. This happens by buying high and selling low. In contrast, the average small-cap value mutual fund investor return was only 0.2 percent below the fund’s performance.

The returns for index mutual fund investors were higher than the returns for the ETF investors for each of the nine style boxes.

And an examination of the five-year returns of more than six dozen ETFs across a range of asset classes by the founder of Vanguard Group concluded that the ETF investors made 18 percent less than the returns of the ETF itself because of the investors’ trading activity.

Unlike mutual funds, ETFs can trade at a premium or discount to their net asset value (NAV). When an ETF investor buys at a premium, he overpays for the asset. Likewise, if he sells at a discount, he receives less than the asset is worth. These premiums and discounts can be wide, especially on days with big NAV changes, and the premiums/discounts can swing very quickly from one extreme to another.

The chart above shows the NAV trading premiums and discounts for the new Market Vectors Junior Gold Miners ETF (GDXJ). Going back to inception, investors have paid premiums to purchase as high as 3.23 percent and sold at discounts as much as 1.28 percent. For the SPDR Gold Shares Trust (GLD), investors paid a 2.15 percent premium to buy in on May 6 (the day of the “flash crash”), but that swung to a 1.3 percent discount just seven trading days later on May 17.

This can work both for and against the investor. Bid-ask premiums or discounts to NAVs can both positively or negatively affect investor return depending on the timing of the transaction. An investor who purchases an ETF at a discount and sells at a premium will receive a higher return than the ETF over the same period of time.

There’s no such thing as a free lunch when it comes to investing. ETFs have relatively low expense ratios compared with actively managed funds in the same sectors, but that doesn’t mean that in the end an ETF costs less to own or that an ETF generates better returns. They can be expensive to trade on volatile days and the events of May 6 uncovered some new weaknesses.

ETFs can have a place in many investment strategies, but before buying, investors need to know what they are getting into so they can make the best decisions consistent with their investment goals.

You can read the full SEC-CFTC Report at SEC.gov. Vanguard’s research is available at IndexUniverse.

Tags: Cap Value, Cftc, Chief Investment Officer, Commodities, Commodities Futures Trading, Commodities Futures Trading Commission, Dow Jones, ETF, ETFs, Exchange Traded Funds, Frank Holmes, Futures Trading Commission, Gold, Hedging Strategies, Institutional Investors, Investor Returns, Morningstar Style, Mutual Fund Investor, Mutual Fund Investors, Registered Investment Advisors, Same Time Period, Style Boxes, U S Global Investors
Posted in Commodities, ETFs, Gold, Markets | Comments Off

India’s Focus on Investor Protection

Monday, April 19th, 2010

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India’s Mumbai Stock Exchange

Week Ended: April 16, 2010

India’s financial sector watchdogs have demonstrated their independence time and again. For example, the country’s central bank, the Reserve Bank of India, was one of the few central banks that chose to break from prevailing global loose monetary policies. India’s other regulator, the Securities and Exchange Board of India (SEBI), which is equivalent to the Securities and Exchange Commission (SEC) in United States, has also come a long way in asserting itself. Established in 1992, SEBI has been making systemic reforms aimed at better corporate governance, deeper capital markets and more satisfied investors.

SEBI’s primary goal has always been investor protection. Its recent efforts to abolish entry and exit loads—sales charges paid by mutual fund investors—has significantly brought down investing costs. SEBI’s recent listing regulations have balanced the interests of minority shareholders with those of promoters intending to delist companies. It has also offered guidelines for enhanced disclosures and mandatory grading of Initial Public Offerings (IPOs). Real estate IPOs, for example, are required to reveal complete ownership details of land banks and report market-determined asset values.

The regulator has also been gradually raising India’s corporate governance standards. A decade ago, SEBI managed to implement the disclosure of quarterly financial results amid huge resistance. Recently, it required the semiannual disclosure of balance sheets, in efforts to limit the scope of any “creative accounting.” SEBI has also asked companies to increase the weight of independent directors on their boards as part of its efforts to create checks and balances. These checks are meant to improve auditor oversight following an accounting scandal that surfaced at a leading technology company early last year.

Developing capital markets has been a high priority for SEBI. About a decade ago, SEBI streamlined security transactions by eliminating the need for investors to hold shares in paper form. This was followed by their push to have exchanges implement online trading capabilities. To improve liquidity and price discovery, it recently introduced short selling and is now enhancing securities lending mechanisms that enable this. SEBI has also proactively introduced new asset classes and exchanges to enable broader capital market participation.

Despite its accomplishments, SEBI still has a lot of unfinished work. For example, the liquidity in India’s capital markets is significantly lower than expected. In addition, SEBI—which currently spurs product innovation—could arguably be better served to leave that function in the hands of the exchanges themselves, and focus on the task of regulating its markets.

Sunil Asnani
Research Analyst
Matthews International Capital Management, LLC

Tags: Accounting Scandal, Asset Values, Bank Of India, Central Banks, Checks And Balances, Corporate Governance Standards, Exchange Board, India, Initial Public Offerings, Investor Protection, Land Banks, Minority Shareholders, Mumbai Stock Exchange, Mutual Fund Investors, Ownership Details, Quarterly Financial Results, Reserve Bank Of India, Sales Charges, Securities And Exchange Board Of India, Securities And Exchange Commission, Systemic Reforms
Posted in India, Markets | 2 Comments »

Articles, Letters and Reports Worth Reading (July 13, 2009)

Monday, July 13th, 2009

Below are some articles we’ve read over the past few days that you might find interesting:

Mutual fund investors’ can’t get it right
http://www.nytimes.com/2009/07/12/business/mutfund/12stra.html?_r=1&adxnnl=1&adxnnlx=1247487780-L6x/BnoonRlvWYfyCGgAsg

Excerpt:

LAST year, investors made a bad situation worse in the bear market by trying to time when to get into and out of stock mutual funds. As a group, they would have lost much less money had they simply held onto whatever funds they owned when the bear market began.

Is it time to buy junk bonds?
http://blogs.wsj.com/deals/2009/07/09/junk-bond-market-shows-signs-of-recovery/

Excerpt:

The high-yield sector has been looking up, up, up as upgrades increased, downgrades decreased and issuance continued to surge in the second quarter of this year.

Jean Marie Eveillard’s View On The Economic Crisis (PDF)

http://www.firsteaglefunds.com/downloads/news/JMEatDD0609.pdf

Here is an excerpt:

Now, this financial crisis was, not to use Nassim Taleb’s metaphor, not a black swan. Nassim Taleb wrote a book, the title of which is The Black Swan, by which he meant something that was unpredictable. Many hundreds of years ago in Europe people believed that there were only white swans because they had never seen a black swan until somebody went to Australia, came back to Europe and said, “Hey, I saw a black swan.” In other words, Nassim Taleb is saying that the mere fact that Europeans had never seen a black swan did not mean necessarily that there was no such thing as a black swan. And yet, almost all professional investors did not see the crisis coming, even though as I said before, it was not an unpredictable event. Because they didn’t see the crisis coming, they said, “Hey, nobody predicted it” or “The only ones who predicted it were people who for decades have been

Howard Marks – So Much That’s False and Nutty [in finance] (PDF)

http://www.oaktreecapital.com/Memos/So%20Much%20Thats%20False%20&%20Nutty_07_08_09.pdf

Here is an excerpt:

There is so much that’s false and nutty in modern investing practice and modern investment banking. If you just reduced the nonsense, that’s a goal you should reasonably hope for. As we look back at the causes of the crisis approaching its second anniversary – and ahead to how investors might conduct themselves better in the future – Buffett’s simple, homespun advice holds the key, as usual. I agree that investing practice went off the rails in several fundamental ways. Perhaps this memo can help get it back on.

Tags: Bad Situation, Bear Market, Black Swan, Downgrades, Economic Crisis, ETF, Europeans, Financial Crisis, high yield, Hundreds Of Years, Issuance, Junk Bond Market, Junk Bonds, Memos, Metaphor, Mutual Fund Investors, Professional Investors, Swans, Unpredictable Event, White Swans, Wsj
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