Exchange-Traded Funds What To Know (ETFs)

For the last several years, Exchange-Traded Funds have been rapidly replacing mutual funds as a common form of investment. They’ve been a favorite of some investors for more than a decade and have recently surged in popularity. But they are not necessarily a significant improvement over mutual funds, the advantages ETFs offer are tempered by several major drawbacks. Both individual and institutional investors have gravitated to them, drawn by their low costs and the broad diversity of their assets. Nonetheless, investors should approach ETFs carefully.  ETFs are structured so they hold a specific group of stocks, such as the S&P 500 or the biotechnology index. Many investors are attracted to these features, as they prefer the specific industry focus an ETF offers them, alongside lower management fees and intraday pricing and selling. The downside of all these properties is that ETFs place a far greater burden of selection and management decisions on the investor, as they are less actively managed than are mutual funds. For these reasons, investors need to examine individual ETFs in depth, and understand their advantages and disadvantages before they make the choice to invest.

Advantages

ETFs offer a range of advantages to the skillful investor. The most important of them are:

Diversification Within a Sector or Index: ETFs generally offer more industry diversification than most mutual funds. For instance, an individual ETF can track a broad range of stocks, such as the Standard & Poor's 500 index, the commercial banking index, or even seek to mirror the returns of a specific country or a group of countries.

Cost: One key reason investors choose ETFs is their low cost relative to the breadth of exposure. By contrast, mutual funds can also offer broad diversification, but typically are accompanied by higher fees. Because ETFs are passively managed, they have much lower expense ratios than mutual funds do.

Trades Like a Stock: Despite their diversification and low costs, ETFs still trade like stocks. This allows investors to easily monitor the changes of a commodity or sector by checking the intraday price of the ETF. Mutual funds on the other hand, do not offer intraday pricing and are priced at the end of the trading day.

Dividends Reinvested Immediately: Dividends earned by the companies invested in ETFs are reinvested immediately, whereas reinvestment timing varies for index mutual funds.

Capital Gains Tax Exposure Limited: ETFs can be more tax-efficient than mutual funds because most of the tax on capital gains is paid when the investor sells the ETF, leaving the choice when to incur the tax in the hands of the investor.  Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities for a profit. This mutual fund distribution is made according to the proportion of the fund holders’ investments, and is taxable as a capital gain. If other investors sell before the date of record, those remaining in the mutual fund divide up the capital gains, and thus pay taxes even if the fund lost value overall.

More Accurate Pricing:  Because ETFs trade throughout the day at a price close to that of the underlying securities, ETF prices only rarely deviate from their actual value.

Disadvantages

Disproportionate Representation of Large Companies: In many ETFs, a few large capitalization stocks make up the majority of the fund’s total value, due to the use of a tool called a “market weighting factor”.  This heightens the effect of an individual company’s stock, as they are often disproportionally invested in the ETF, potentially with negative effects. For example, as of March 31, 2019, Vanguard's Total Stock Market ETF (VTI) comprises 3615 holdings, of which the top ten holdings account for 18.6% of the fund’s value. As of April 22, 2019, the very popular “DIA” ETF, which tracks the Dow Jones Industrial Average, the top five companies (out of 30) contribute approximately 31% of the value, meaning their weighting is over twice as heavy as the other 25 holdings.   Additionally, overweighting by market cap can have the effect to also overweigh an industry sector and to affect fund performance. It also leaves the ETF vulnerable to wild fluctuations when markets are going down, effectively exaggerating market volatility. For instance, when investors liquidate their ETF holdings over concerns about the impending tariffs or recessions, over-represented companies in that ETF may lose the most value, as they are the most heavily owned and they will be sold first.

Costs Could Actually Be Higher: Most analysts compare Exchange-Traded Funds to other pools of stocks, such as mutual funds, and note their comparatively low management costs, which is accurate.  But if you compare management fees on ETFs to investing directly in a specific stock, the costs may be higher, as there is not a management fee to hold a stock. 

Leveraged ETF Returns Can be Skewed: Investing in ETFs that are double- or triple-leveraged can sometimes result in losing more than double or triple the tracked index itself. These types of speculative investments need to be carefully evaluated. For instance, if you own a double leveraged natural gas ETF, a 1% change in the price of natural gas could result in a 2% change in the ETF on a daily basis.

The Bottom Line:  Overall, we believe ETFs have a place in well-built portfolios, if used prudently and in limited roles. They can be helpful in gaining diversification, exposure to specific sectors and they offer certain advantages when compared to mutual funds.  ETFs can be traded quickly and easily like stocks, but their price movements are more akin to entire indexes.  ETFs which are market weighted may be especially volatile in a down market.

In summary: Exchange-Traded Funds require careful management. Their low expenses, high diversification, and ease of selling set them apart from more management-heavy mutual funds, but investors need to be keenly aware of the risks associated with concentration in specific stocks issues.

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