Exchange-traded funds, or ETFs, have gained popularity in recent years, amassing close to $2 trillion in assets.1 ETFs come in many shapes and sizes: the plain-vanilla funds are similar to index mutual funds, with the added flexibility of allowing investors to trade throughout the day. Other ETFs follow a more complex strategy — some promise the inverse of an index, while others are leveraged to provide double or triple the return on an index.
Most long-term investors are better served steering clear of the latter — complex ETF strategies that are opaque, speculative and often contain hidden risks. But what about the ETFs that track broadly diversified indices? Do they make sense for the long-term investor?
At first blush, plain-vanilla ETFs appear to offer the best of both worlds — they can, as one Vanguard ETF tagline reads, “combine the diversification and management of a mutual fund with the trading flexibility of a stock.”2
Not so fast. ETFs are relatively new to the financial markets, and like any new, “improved” product, it can take time to work out the kinks. Think Apple iPhone 4: although it boasted a slimmer design, the wraparound antenna resulted in poor reception and more dropped calls than earlier versions.
In the case of ETFs, the “kink” that needs to be worked out is how effectively the vehicles’ stock-like trading flexibility works during periods of market volatility. We saw a prime example of this on August 24, 2015; a recent Barron’s article recalled that “when the S&P 500 fell as much as 5.3 percent in the opening minutes of trading, the $65 billion iShares Core S&P 500 ETF fell as much as 26 percent, some 20 percentage points below its fair value.”3
This wasn’t an isolated incident — in fact, more than 300 ETFs across major providers halted trading on August 24 due to pricing issues.4 In times of market turbulence, the market price of an ETF can deviate substantially from the underlying securities it tracks. Nevertheless, a long-term investor who used one of these ETFs and did not trade the morning of August 24 would have had a similar experience to an index mutual-fund investor once normal trading of those ETFs resumed.
No harm, no foul — why does this even matter?
If an investor does happen to sell an ETF at a time when it’s trading at a discount to the value of its underlying securities, he or she could face a measurable economic disadvantage. Also, by promising greater liquidity, ETFs also encourage investors to try to move in and out of the markets. Not only is this typically a losing strategy, it can be costly, especially if an investor ends up trading on a morning like August 24.
Since liquidity in these vehicles can break down during turbulent markets, ETFs’ advantage relative to their time-tested, mutual fund predecessors (which have been around since 1928) has been overstated. The other oft-cited advantages of ETFs over mutual funds are that ETFs cost less and are more tax-efficient. However, when you compare the cost and tax efficiency of passively managed, tax-aware mutual funds to ETFs, these two benefits virtually disappear.
Intraday trading in ETFs (when it works) may be helpful to day traders and hedge funds, but it is not necessary for long-term investors. The structure of ETFs enables the “fast money” to make bets and unwind positions on a whim. A huge business has been built serving the needs of these short-term investors, but that does not make it a better choice for long-term investors.
With ETFs, investors are not buying from or selling directly to a fund company; instead, they purchase the ETF on an exchange, which can result in substantial bid-ask spreads, a hidden transaction cost that can be higher than the transaction cost of trading a mutual fund. Further, mutual funds often provide deeper and broader market exposure — especially in less liquid asset classes, such as emerging markets and high-yield bonds — within a more reliable vehicle than ETFs.
The mutual fund structure has served investors well for decades. As careful stewards of our clients’ assets, we have chosen not to adopt widespread use of ETFs. While we do and will incorporate ETFs in our portfolios for special circumstances (for instance, if a certain strategy is limited in a mutual fund format, or if a client’s situation requires it), our preference is to stick with tried-and-true mutual funds over ETFs.
Investors who do primarily use ETFs must be aware of how these vehicles behave during periods of market volatility, and be vigilant about price deviations when they are trading. It’s important to have confidence in the price at which you transact in securities.
The markets can provide a bumpy-enough ride on their own; you don’t want to be in a vehicle that could break down.