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Stripping the ETF

By: Investor Solutions

By: Investor Solutions

There are currently over 300 offerings available in the Exchange Traded Fund arena from giant asset managers such as Barclays Global Investors and Vanguard. Although they have been around since the mid 1990s, their popularity has continued to increase with individual and institutional investors alike. ETFs are an excellent, low cost, tax efficient method of capturing the world’s markets and should be a component of every passive investor’s portfolio. Let’s deconstruct the ETF and show the active investor once and for all that it is an important ingredient in an optimal, i.e. – passive, portfolio.

Composition

Exchange traded funds are simply mutual funds comprised of a basket of securities that trade on an exchange in the same fashion as stocks. In contrast to regular open end mutual funds which trade at the end of day’s Net Asset Value (NAV), ETFs can be bought and sold throughout the day. This allows investors to lock in a specific price at which they will buy or sell the fund. Because shares are constantly being sold, it is possible to buy or sell at other than NAV. This allows large institutional investors to capitalize on the opportunity to buy an investment at a low price and then turn around and sell it at a higher price and thereby profit from the “spread”. Although irrelevant to long term investors, ETFs, like stocks, can be shorted or bought on margin.

Asset Class Availability

The gamut of asset classes represented by ETFs is practically all inclusive. You can find ETFs for domestic and international, large, mid and small cap, growth and value funds. Also available are fixed income offerings. Let us not forget that REITs and commodities as well as region and sector specific investments are also accessible to us by way of ETFs. You will, however, be hard pressed to find an International Small Growth and Value ETF. Nevertheless, you can supplement your ETF portfolio with traditional low cost index funds in order to gain exposure to these asset classes.

Cost

In general, ETFs have a considerably lower expense ratio than the majority of mutual funds. Expense ratios range from .07% for the Vanguard Large Cap Viper to 1.43% for the iShares Japan Index. With ratios like these, ETFs might appear to be the obvious choice. However, unlike traditional mutual funds, investors must pay commissions set by the broker to buy and sell ETFs. Although the amount of these commissions has decreased over the years, they can add up to a significant amount in certain circumstances. For investors looking to make a one time, lump sum investment, an ETF may be the optimal choice. On the other hand, passive investors who periodically contribute a sum of money to their portfolio, such as with dollar cost averaging, would end up paying more by purchasing an ETF than with many traditional mutual funds as would active traders who are constantly buying and selling. This additional cost would result in a reduction of the portfolio’s future value and the investor’s ultimate wealth. Let’s take a quick look at some of the most common traditional mutual funds and how they compare to their ETF counterparts.

Vanguard Large Cap ETF (VV) iShares Russell 1000 Growth Index (IWF Fidelity Magellan (FMAGX) Janus Adviser Large Cap Growth (JDGAX)
Expense Ratio 0.07 0.20 0.59 0.91
Front End Load 0.00 0.00 0.00 5.75
Deferred Load 0.00 0.00 0.00 0.00
Vanguard Small Cap Growth ETF (VBK) iShares Russell 2000 Growth Index (IWO) Salomon Bros. Small Cap Growth A Oppenheimer Discovery A
Expense Ratio 0.12 0.25 1.15 1.26
Front End Load 0.00 0.00 5.75 5.75
Deferred Load 0.00 0.00 0.00 0.00

Taxability

Unlike traditional mutual funds that can be bought from or sold to the fund company, ETF transactions occur mostly between shareholders. This protects the fund company from having to sell shares of the underlying stocks to meet the redemptions. This, in turn, protects the investor from paying taxes on capital-gain distributions generated by the fund. Instead, capital gains are generally deferred and paid upon sale of the ETF by the investor. Upon selling, the amount of taxes depends on the funds appreciation since its purchase, the date on which it was purchased and the investor’s marginal tax rate. Be aware, however, that because ETFs track a specific index, taxable capital gain transactions do occur when the fund company must alter the fund’s underlying investments in order to match its benchmark.

It is worth repeating that exchange traded funds are excellent, low cost, tax efficient investment vehicles. With all of these features and extensive asset class representation, you would think they would be the obvious investment choice for investors. Unfortunately, many investors remain in search of the ever elusive perfect portfolio. Well, search no further. For a long term investor, the perfect portfolio is globally diversified among various asset classes and comprised of ETFs and low cost index funds.