Both quantitative and qualitative considerations will help investors decide whether exchange traded funds or conventional fund shares will be most beneficial to their portfolios
For investors, exchange traded fund shares (ETFs) present an alternative way to invest in index mutual funds. After their introduction in Europe in 2001, ETFs have gained increased acceptance and use by the investment community. While there may be important legal and regulatory differences, the relative attractiveness of conventional fund shares and ETFs generally depends on a few simple qualitative and quantitative considerations.
While the qualitative considerations focus on the investor's required level of trading flexibility, the primary quantitative consideration is cost, which is a function of the amount initially invested, time horizon, and plans for subsequent investments. These considerations suggest that different fund structures are appropriate for investors with different profiles:
Trading flexibility: The most significant factor influencing the decision between ETFs and conventional shares should be the desire for trading flexibility. The exchange trading of ETFs provides intra-day pricing and execution, meaning that investors can obtain relatively certain pricing. This is not possible with conventional fund shares which are priced once a day at the close of trading. Intra-day pricing and execution of trades can help investors implement a number of strategies:
• Investors can try to establish a position in a market segment, sector or country at any point during the day.
• Sell short and place orders at prices other than at the market's close. The ability to sell short or to place stop and limit orders can be a powerful advantage for investors hedging against declines in a 'long' portfolio position. Stop and limit orders can also be set as open orders for up to 30 days, and are either executed or expire.
• ETFs are marginable and can be a source of capital for investment or for unexpected liquidity needs.
Greater trading flexibility can be quite helpful. However, this feature can also backfire. Buying on margin and selling shares short can be extremely risky. Because of transaction costs and the difficulty of properly timing performance shifts between countries, markets or sectors, most investors who engage in tactical investment strategies using ETFs have difficult hurdles to overcome in order to do better than those who following strategic asset allocation strategies.
Cost analysis: If an investor does not value the trading flexibility of ETFs, then the cost differential should be the next most important consideration. Since the performance of ETFs and conventional shares with the same underlying index benchmark should be very similar before costs, the lowest-cost share alternative is expected to deliver higher after-cost returns.
Cost is usually less important than qualitative considerations in determining whether to invest in ETFs or conventional shares of an index fund. For many investors, the sense of control from the trading features of ETFs may be more attractive unless the conventional shares are considerably less costly.
The greater the expense advantage for the ETF relative to a comparable conventional index fund, the greater this appeal may be. If the total expense ratio differential favors the ETF by a large enough degree, one could suggest that the investor receives the trading flexibility for 'free'.
Frequently, however, the cost differential is relatively small and is sensitive to the assumptions used in the analysis. As a result, the investor needs to consider that over time, their actual experience may not mirror their assumed experience. For ETFs - where unexpected investments or redemptions are necessary - the expected cost savings may not be realised.
Great care needs to be taken when selecting 'comparable' fund alternatives, as there can be significant tracking error among index funds, even when the benchmark objectives are identical. It is also critical that cost comparisons be made appropriately. Comparing ETFs to actively managed funds or using total expense ratio averages can lead to erroneous conclusions regarding cost savings. On average, the total expense ratios for ETFs are less than 0.5%, while the total expense ratios for index mutual funds and actively managed mutual funds can exceed 1.0%. In practice, however, cost differentials can be much narrower than these averages may suggest.
The costs associated with ETFs differ from those associated with conventional shares in two primary ways:
Trading costs: ETF trades are executed through brokerage accounts and are subject to commissions and the bid-asked spread. The number of shares transacted generally determines these costs: larger dollar value transactions or lower priced ETFs can increase trading costs, particularly the bid-asked spread. No such fees exist for conventional shares, although some funds may charge sales loads or transaction fees. Investors should make sure that all relevant investment costs are captured in the cost analysis.
Total expense ratios. Unlike trading costs, which are transaction-based, fund total expense ratios represent the investment management and administrative costs of operating the fund as an ongoing concern. Differentials between total expense ratios can provide enduring cost savings if transaction-related fees are not significant. Generally speaking, ETFs may carry lower expense ratios than conventional fund shares.
For certain investors, the additional features available from ETFs, but not from conventional shares, may make them the higher value proposition, even if the ETFs are not the lower cost alternative. Nonetheless, a quantitative analysis of cost-effectiveness can help investors to decide which share class may be right for their portfolios, given their unique investments circumstances.
Another factor in the cost analysis is time horizon. This consideration is most relevant for investors who establish a position for the long run and who do not intend to make periodic investments or redemptions. In this case, the transaction-related costs occur once, at the initial purchase of shares, but their total expense ratio savings may continue year after year. Depending on the total expense ratio differential and amount of transaction costs incurred, the ETF may be the more cost effective choice for investors who are establishing a portfolio holding for the long term.
Another important variable in the cost analysis is the frequency of an investor's transactions. Investors who make systematic investments or redemptions generally incur lower overall costs with conventional shares. In some cases, the conventional shares may have higher expense ratios than a comparable ETF, but the total expense ratio advantage of the ETF can be quickly overwhelmed by transaction-related costs. For investors making periodic investments or redemptions, the cost savings from the ETF's total expense ratio would likely need to be sizable (to offset the added transaction costs) before the ETF would be the more cost effective solution.
Comparisons of investment structures need to extend beyond the obvious total expense ratios. Various quantitative and qualitative factors should be considered in determining whether to invest in index funds through ETFs or through conventional shares. Because the cost differences are not usually large, the qualitative factors should be addressed first, beginning with an investor's desire for trading flexibility. However, an investor needs to consider their anticipated investment time horizon and frequency of investments. A shorter holding period and frequent transactions will generally adversely affect the viability of the ETF solution. Analysis can reveal the most cost-effective share class for an investor, based on the investor's assumptions, but expected cost savings may never materialise. In many situations ETFs may seem to be the lower cost solution, but unanticipated transactions or unexpectedly high transaction costs can erode some or all of the potential cost benefits. Since these cost savings tend to be modest even over longer time frames, the final decision should be driven primarily by the value the investor places on ETFs' additional - and more certain - trading features. For investors with larger investment balances and less assurance regarding their future investment circumstances, choosing conventional index funds can deliver higher degrees of cost certainty.
Various quantitative and qualitative factors should be considered in determining whether to invest in index funds through ETFs or through conventional shares.
An investor's desire for trading flexibility should be addressed first.
Choosing conventional index funds can deliver higher degrees of cost certainity.
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