Most people are familiar with the mutual fund structure. These are “pooled” funds of diversified investments managed by investment professionals and regulated by the Securities and Exchange Commission (SEC). Investors buy shares in the mutual funds and share in the investment performance; both up and down. At the end of each day, all holdings in the fund are valued and a “net asset value” (NAV) is calculated and used for all activity in the fund that took place that day.
Exchange-traded funds (ETFs) are just like mutual funds except they are traded on an “exchange” just like regular stocks. ETFs also have a net asset value except it is calculated continuously during the day allowing the ETF to be traded all day long. But, the ETF does not necessarily trade at the NAV but usually trades at bid/ask prices that are a bit higher/lower than the NAV to compensate the exchange.
ETFs have several advantages over mutual funds. Most importantly, the ability to trade during the day is a major advantage for risk management purposes. For example, let’s say you had a portfolio of mutual funds and you wanted to rebalance to a different strategy. In this case you would sell the mutual fund on the night before and would not have the proceeds to reinvest until the next day! There are ways to minimize this risk, but this structure still exposes the investor to basis risk because the markets could move overnight and you would be forced to reinvest at a higher price than expected.
Another major advantage is the broad selection of passive diversified ETFs that track major indices, thus eliminating behavioral bias and active management that could hurt performance.
Also, because of the mechanism used to create/redeem ETF shares, most ETFs avoid the need to pay capital gains distributions; a major benefit for investors in taxable accounts. Another benefit is the generally lower investment expenses compared to mutual funds, though this benefit is slowly disappearing due to competitive pressures.
The major disadvantage of ETFs is the aforementioned bid/ask structure. For ETFs with low volume or other unique characteristics, the bid/ask spread could be very large thus costing the investor a high “implicit” fee on transactions.
D&A favors ETFs for most client accounts because of the benefits indicated above; especially the risk management aspect and the ability to invest in a broad selection of passive diversified ETFs to help target investment strategies tailored for our clients. Also, because D&A usually invests only in the most liquid ETFS and trades relatively infrequently, the potential for higher bid/ask expenses is reduced. And finally, the generally lower investment expenses embedded in ETFs is an advantage for our clients.