Many investors, both professional and amateur, have been bombarded over the last five years with advertisements and articles about Exchange Traded Funds or ETFs. In 2016, a record $375 billion flowed into ETFs globally. There are countless arguments for the use of them and perhaps the same volume of arguments against them. As advisors, we often have clients that request that their portfolios contain ETFs, and in some cases, that they do not contain ETFs. As a way to shed some light on the topic, here are some key questions that, as an advisor, I consider when deciding “to ETF or not to ETF” in a portfolio.
How much money is being invested?
Since an ETF by definition is a basket of securities, rather than a single security (stock, bond, commodity contract, REIT, etc.), there is immediate diversification that will be gained by buying an ETF versus individual security. So for a more modest investment either in total account value or in the desired area of exposure, it often will make sense to use an ETF to reduce expenses associated with trading costs and, in contrast to a mutual fund, there can be a substantially lower management fee (expense ratio) and never a sales load.
What type of asset exposure is desired for the funds?
To put this more simply, are we trying to buy stocks, bonds, commodities, a geographic region, a specific sector, short strategy, or some other specialty? Some areas of desired investment are either extremely vast or volatile or both. An ETF may offer an inexpensive way to get diversified exposure to a wide range of securities that may be difficult to buy for a variety of reasons, including their price per share, trade on foreign stock exchanges, or that they may be a commodity. These are also some of the reasons one might use a mutual fund. The key differentiator has to do with the strategy used to pick the securities. ETFs tend to be passive investment vehicles that simply buy an index or an equal amount of a certain group of securities. This is in contrast to most mutual funds that aim to select a specific group of securities with the expectation of outperforming a given benchmark. Following the Great Recession, as securities markets have recovered, it has been a tough period for active managers, as many have failed to outperform their benchmarks. As such, passive investments have grown in popularity for their low costs and simple strategies. There have been many in the investment community that believe that as correlations between returns of specific stocks trend lower due to the late cycle of economic recovery, active managers, particularly stock pickers, are now coming into a period where they should shine, proving their worth and earning their fees.
What type of account? Tax-deferred, tax-free or taxable?
A key consideration for investors has to do with the taxable nature of the investment account in question. In a tax-deferred account such as a 401(k), IRA, or SEP IRA, taxable events concerning capital gains distributions, dividends or interest are not taxable until funds are withdrawn from the account and there is no distinction between contributions or earnings. As such, using an ETF that may be more tax-efficient than a mutual fund should not be of much concern. For an account that is taxable, this may be an important concern. Turnover in a portfolio that causes capital gains may result in a taxpayer getting hit with a large tax bill they were not expecting, even if they made no trades during the tax year. This can even occur in years where the market is down but fund managers sell some of their winners, which generates a realized gain in the portfolio. It is important to review the historical turnover for a prospective mutual fund or ETF to gain some perspective on what to expect in the future. ETFs tend to be more tax efficient due to their passive nature, as holdings are rarely sold.
What is the expected holding period of the fund?
Shorter holding periods certainly favor the use of an ETF. As they are traded throughout the day during stock market hours, they are highly liquid. There also tend to be little or no up-front sales charges beyond some small potential commission or ticket charge depending on the type of account the client opts to use: typically, brokerage or advisory. Many mutual funds may have short term trading penalties and restrictions that either totally prevents or just discourage selling funds within a month or two. A longer holding period may favor a manager that tends to outperform over the longer term of multiple years but may underperform or mirror the benchmark in the shorter term.
Is the account managed by an advisor or in a model portfolio?
Fee-based accounts will allow advisors to get their clients access to the lowest share class available for a specific mutual fund. This will also allow an investor to use a mutual fund without a sales load. This results in a more flexible time horizon rather than having to hold a fund for 5 or more years to recover the initial sales charge. ETFs can be used cost-efficiently in a brokerage account as there is no sales charges involved, only a nominal trade ticket charge. In a fee-based account, they are just as useful for all of the reasons stated above.
The bottom line
The choice to use an ETF or a mutual fund often comes down to a consideration of all of the factors discussed above in addition to other factors more specific to each asset class. ETFs are a great tool in the bag for an investor or advisor. Just as with any other tool, it should be utilized for the appropriate job.