Gus Sauter argues that promoting one form of indexing over another in the ETF versus Index debate is futile as they both have a place in a portfolio
Much has been written about the arrival of exchange traded funds (ETFs) in Europe, with most of the commentary suggesting that ETFs are a superior alternative to index- tracking funds. I would suggest that promoting one form of indexing over the other is too simplistic, and believe that each may have its place in an investor's portfolio.
Since ETFs are traded on an exchange, their most attractive feature is the ability to be bought or sold at any time during the trading day. ETFs have made broadly diversified investments that offer an exceptionally high degree of liquidity available to millions of investors. That ETFs follow an indexing approach ' a proven strategy for investment success over time ' is well known and need not be discussed further here. Once an investor determines to pursue the tracker strategy, the only question to be answered is which is the optimal approach ' index fund or ETF? Surprisingly, there is not a universal answer. In fact, the answer could be that holding both is the best approach. Several factors should be considered when deciding which indexed investment to choose. They are presented in the table.
Why do the latter factors favour traditional index funds? The answer is cost. The impact of brokerage commissions on an investment in ETFs is often overlooked. Those commissions are paid on each contribution to ' and each withdrawal from ' an investor's account. Some brokers charge fees to reinvest dividends and capital gains distributions made by ETFs. The impact of brokerage commissions over time can be meaningful, and can negate any total expense ratio cost savings.
Several myths have arisen around ETFs, and some are being accepted, even though there is little or no basis in fact for them.
ETFs have lower costs than index funds. On its face, this myth appears to be true. According to research company Fitzrovia International, the total expense ratio on an ETF in Britain is between 0.49% and 0.74%, while the average index-tracking index fund's expense ratio is 1.05%.
However, there are tracker funds with expense ratios lower than the average ' one is offered at 0.38%. Moreover, brokerage commissions must be added to the cost of an ETF investment.
On a $5,000 purchase, a mere $28 brokerage fee consumes the entire expense ratio differential at its maximum (and this fee must be paid again when the investor redeems). Some tracker index funds can be purchased without paying a brokerage fee, or with only a very modest purchase fee. Finally, investors in ETFs may incur the cost of bid/offer spreads ' the difference between the price a dealer will pay for a security and the somewhat higher price the dealer will sell the same security. These spreads can range from 0.5% to nearly 1.5%. Shares of some index funds can be bought or sold directly through the investment management firm without bid/offer spreads.
Since ETFs are tracker funds, that is how they all perform. There is a tendency to believe that all tracker funds perform alike, and so the same is true for ETFs. This is untrue. In a research paper prepared by two professors and two doctoral candidates at the Stern School of Business at New York University last year, one of the most popular ETFs that tracks the S&P 500 Index was found to have underperformed the leading S&P 500 index fund by more than 18 basis points per year. There is a meaningful difference between tracker managers regardless whether the manager is managing a index fund or an ETF.
ETFs do not trade at a discount to NAV. Research conducted by Salomon Smith Barney and others in the US has found frequent, though modest, trading at discounts or premiums to NAV. While the ETF pricing rarely strayed more than 1% away from NAV, even a half or quarter of a percent will add to an investor's implicit costs and could offset any annual expense ratio advantage that an ETF may have.
ETFs are a large part of the US fund market. ETF assets have grown sharply in the past year, reaching some US$77bn ' or about 2.5% of the US$3.1 trillion equity fund market. Those assets have come not at the expense of traditional tracker funds, which are continuing to see high levels of net cash inflows. Thus, it seems that ETFs are expanding the overall market for tracker investments.
ETFs are owned primarily by long-term investors. A very popular ETF in the US is the Spider, which tracks the S&P500 Index. Its turnover rate is 1,400%, compared to a redemption rate of about 10% for a traditional index fund. Qubes, which are based on the Nasdaq 100 index, trade more than four times as frequently as Spiders ' up to 40 million shares per day, versus up to eight million Spider shares. Average holding periods are measured in hours, not years.
ETFs are for everyone. Actually, this may not be a myth. ETFs are a well crafted offering for investors who desire the highest degree of trading flexibility together with a broadly diversified investment.
They may also be appropriate for investors who plan to make a single, sizable investment and to hold it for many years. Investors who do not want or need trading flexibility, or those who will be making regular investments into or withdrawals from their account, may be better served by a traditional index-tracking index fund. It may even be suitable to hold both an ETF and a traditional index-tracking index fund in the same portfolio, given that each brings certain attributes that may be desirable in an overall investment approach. So the decision may not be between an ETF or an index-tracking index fund, but rather what proportion of an overall portfolio to hold in each.
By George U Sauter, managing director and head of the quantitative equity group at The Vanguard Group
Gus Sauter is the portfolio manager for the Vanguard 500 Index Fund, the world's largest mutual fund with US$86bn in assets, as well as the Vanguard Total Stock Market VIPER, the ETF share class of Vanguard's Total Stock Market Index Fund.
Both ETFs and index tracking funds have their place in an investor's portfolio.
ETFs can be bought or sold at any time during the trading day.
ETFs are a well-crafted offering for those who desire a large degree of flexibility and a broadly diversified investment
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