Trading in large lots

Prior to the introduction of ETFs, a trader had no easy way to buy or sell instantaneously, in one fell swoop, hundreds of stocks or bonds. Because they trade both during market hours and, in some cases, after market hours, ETFs made that possible.

Institutional investors also found other things to like about ETFs. For example, ETFs are often used to put cash to productive use quickly or to fill gaps in a portfolio by allowing immediate exposure to an industry sector or geographic region.

Savoring the versatility

Unlike mutual funds, ETFs can also be purchased with limit, market, or stop-loss orders, taking away the uncertainty involved with placing a buy order for a mutual fund and not knowing what price you’re going to get until several hours after the market closes. See the sidebar, “Your basic trading choices (for ETFs or stocks),” if you’re not certain what limit, market, and stop-loss orders are.

And because many ETFs can be sold short, they provide an important means of risk management. If, for example, the stock market takes a dive, then shorting ETFs — selling them now at a locked-in price with an agreement to purchase them back (cheaper, you hope) later on — may help keep a portfolio afloat. For that reason, ETFs have become a darling of hedge fund managers who offer the promise of investments that won’t tank should the stock market tank. See Chapter 23 for more on this topic.

The cost advantage: How low can you go?

In the world of actively managed mutual funds (which is to say most mutual funds), the average annual management fee, according to the Investment Company Institute and Morningstar, is 0.63 percent of the account balance. That may not sound like a lot, but don’t be misled. A well-balanced portfolio with both stocks and bonds may return, say, 5 percent over time. In that case, paying 0.63 percent to a third party means that you’ve just lowered your total investment returns by one-eighth. In a bad year, when your investments earn, say, 0.63 percent, you’ve just lowered your investment returns to zero. And in a very bad year…you don’t need me to do the math.

Active ETFs, although cheaper than active mutual funds, aren’t all that much cheaper, averaging 0.51 percent a year, although a few are considerably higher than that.

I’m astounded at what some funds charge. Whereas the average active fund charges between .51 (for ETFs) and 0.63 percent (for mutual funds), I’ve seen charges five times that amount. Crazy. Investing in such a fund is tossing money to the wind. Yet people do it. The chances of your winding up ahead after paying such high fees are next to nil. Paying a load (an entrance and/or exit fee) that can total as much as 6 percent is just as nutty. Yet people do it.

In the world of index funds, the expenses are much lower, with index mutual funds averaging 0.06 percent and ETFs averaging 0.17 percent, although many of the more traditional indexed ETFs cost no more than 0.06 percent a year in management fees, and as more competition has entered the market, even that price now seems high. A handful are now under 0.03 percent. And one purveyor, BNY Mellon, has actually introduced two ETFs with NO fees.

No fees?

Uncle Sam’s loss, your gain

Alas, unless your money is in a tax-advantaged retirement account, making money in the markets means that you have to fork something over to Uncle Sam at year’s end. That’s true, of course, whether you invest in individual securities or funds. But before there were ETFs, individual securities had a big advantage over funds in that you were required to pay capital gains taxes only when you actually enjoyed a capital gain. With mutual funds, that isn’t so. The fund itself may realize a capital gain by selling off an appreciated stock. You pay the capital gains tax regardless of whether you sell anything and regardless of whether the share price of the mutual fund increased or decreased since the time you bought it.

There have been times (pick a bad year for the market — 2000, 2008,…) when many mutual fund investors lost a considerable amount in the market, yet had to pay capital gains taxes at the end of the year. Talk about adding insult to injury! One study found that over the course of time, taxes have wiped out approximately 2 full percentage points in returns for investors in the highest tax brackets.

In the world of ETFs, such losses are very unlikely to happen. Because most ETFs are index-based, they generally have little turnover to create capital gains. Perhaps even more importantly, ETFs are structured in a way that largely insulates shareholders from capital gains that result when mutual funds are forced to sell in order to free up cash to pay off shareholders who cash in their chips.

Market makers and croupiers

In the world of ETFs, you don’t have croupiers, but you have market makers. Market makers are people who work at the stock exchanges and create (like magic!) ETF shares. Each ETF share represents a portion of a portfolio of stocks, sort of like poker chips represent a pile of cash. As an ETF grows, so does the number of shares. Concurrently (once a day), new stocks are added to a portfolio that mirrors the ETF. See Figure 2-1, which may help you envision the structure of ETFs and what makes them such tax wonders.

When an ETF investor sells shares, those shares are bought by a market maker who turns around and sells them to another ETF investor. By contrast, with mutual funds, if one person sells, the mutual fund must sell off shares of the underlying stock to pay off the shareholder. If stocks sold in the mutual fund are being sold for more than the original purchase price, the shareholders left behind are stuck paying a capital gains tax. In some years, that amount can be substantial.

In the world of ETFs, no such thing has happened or is likely to happen, at least not with the vast majority of ETFs, which are index funds. Because index funds trade infrequently, and because of ETFs’ poker-chip structure, ETF investors rarely see a bill from Uncle Sam for any capital gains tax. That’s not a guarantee that there will never be capital gains on any index ETF, but if there ever are, they are sure to be minor.

The actively managed ETFs — currently a small fraction of the ETF market, but almost certain to grow — may present a somewhat different story. They are going to be, no doubt, less tax friendly than index ETFs but more tax friendly than actively managed mutual funds. Exactly where will they fall on the spectrum? It may take another few years before we really know.

Tax efficient does not mean tax-free. Although you won’t pay capital gains taxes, you will pay taxes on any dividends issued by your stock ETFs, and stock ETFs are just as likely to issue dividends as are mutual funds. In addition, if you sell your ETFs and they are in a taxable account, you have to pay capital gains tax (15 percent for most folks; 20 percent for those who make big bucks) if the ETFs have appreciated in value since the time you bought them. But hey, at least you get to decide when to take a gain, and when you do, it’s an actual gain.

ETFs that invest in taxable bonds and throw off taxable-bond interest are not likely to be very much more tax friendly than taxable-bond mutual funds.

ETFs that invest in actual commodities, holding real silver or gold, tax you at the “collectible” rate of 28 percent. And ETFs that tap into derivatives (such as commodity futures) and currencies sometimes bring with them very complex (and costly) tax issues.

Taxes on earnings — be they dividends or interest or money made on currency swaps — aren’t an issue if your money is held in a tax-advantaged account, such as a Roth IRA. I love Roth IRAs! More on that topic when I get into retirement accounts in Chapter 24.

What you see is what you get

A key to building a successful portfolio, right up there with low costs and tax efficiency, is diversification, a subject I discuss more in Chapter 4. You cannot diversify optimally unless you know exactly what’s in your portfolio. In a rather infamous example, when tech stocks (some more than others) started to go belly up in 2000, holders of Janus mutual funds got clobbered. That’s because they learned after the fact that their three or four Janus mutual funds, which gave the illusion of diversification, were actually holding many of the same stocks.

Consider a few impressive numbers

By investment professionals, Lord knows I’m not talking about stockbrokers or variable-annuity salesmen, or my barber, who always has a stock recommendation for me. I’m talking about the managers of foundations, endowments, and pension funds with $1 billion or more in invested assets. By amateurs, I’m talking about the average U.S. investor with a few assorted and sundry mutual funds in their 401(k).

Let’s compare the two: During the 30-year period from 1990 through to the end of 2020, the U.S. stock market, as measured by the S&P 500 Index, provided an annual rate of return of 10.7 percent. Yet the average stock fund investor, according to a study by the Massachusetts-based research firm Dalbar, earned an annual rate of 6.24 percent over that same period. The Bloomberg-Barclays U.S. Aggregate Bond Index earned 5.86 percent a year over that same period, while the average bond fund investor earned but 0.45 percent.

Why the pitiful returns? Although there are several reasons, here are three main ones:

• Mutual fund investors pay too much for their investments.
• These investors jump into hot funds in hot sectors when they’re hot and jump out when those funds or sectors turn cold. (In other words, they are constantly buying high and selling low.)
• Small investors panic easily, and all too often cash out when the going gets rough.

Professionals tend not to do those things. To give you an idea of the difference between amateurs and professionals, consider this: For the 10-year period ended December 31, 2020, the average small investor, per Dalbar, earned a 4.9 percent annual return on their investments. Compare that to, say, the endowments of MIT (11.4 percent), Yale (10.9 percent), or Dartmouth (10.4 percent).

You can do what they do!

Professional managers, you see, don’t pay high expenses. They don’t jump in and out of funds. They know that they need to diversify. They tend to buy indexes. They know exactly what they own. And they know that asset allocation, not stock picking, is what drives long-term investment results. In short, they do all the things that an ETF portfolio can do for you. So do it. Well, maybe…but first, read the rest of this chapter!

The index advantage

The superior returns of indexed mutual funds and ETFs over actively managed funds have had much to do with the popularity of ETFs to date. As discussed, the vast majority of ETFs — 77 percent in terms of actual numbers, and nearly 98 percent in terms of assets — are index funds (which buy and hold a fixed collection of stocks or bonds). And, as index funds, they can be expected to outperform actively managed funds rather consistently. According to Standard & Poors SPIVA Scorecard, 88 percent of large-cap core stock funds underperformed their benchmark index in the past five years. High yield bond funds? Ninety-five percent underperformed. Flipping that around, only 5 to 12 percent of actively managed funds succeeded at beating the index funds.

Here are some reasons why index funds (both mutual funds and ETFs) are hard to beat:

• They typically carry much lower management fees, sales loads, or redemption charges.
• Hidden costs — trading costs and spread costs — are much lower when turnover is low.
• They don’t have cash sitting around idle (as the manager waits for what they think is the right time to enter the market).
• They are more — sometimes much more — tax efficient.
• They are more “transparent”; you know exactly what securities you are investing in.

Perhaps the greatest testament to the success of index funds is how many allegedly actively managed funds are actually index funds in (a very expensive) disguise. I’m talking about closet index funds. According to a report in Investment News, a newspaper for financial advisers, the number of actively managed stock funds that are closet index funds has tripled over the past several years. As a result, many investors are paying high (active) management fees for investment results that could be achieved with low-cost ETFs.

R squared is a measurement of how much of a fund’s performance can be attributed to the performance of an index. It can range from 0.00 to 1.00. An R squared of 1.00 indicates a perfect match: When a fund goes up, it’s because the index was up — every time; when the fund falls, it’s because the index fell — every time. An R squared of 0.00 indicates no such correlation. This measurement is used to assess tracking errors and to identify closet index funds.

According to a study done by Credit Suisse, of all the funds in America — both mutual funds and ETFs — 27 percent are true index funds, 58 percent are actively managed funds, and a full 15 percent are closet index funds, meaning they invest as an index fund would, but charge what an active fund would.

When you get to Chapter 25, I’ll fill you in on how you can readily recognize — and avoid! — purchasing a closet index fund.

The allure of active management

Speaking in broad generalities, actively managed mutual funds have been no friend to the small investor. Their persistence remains a testament to people’s ignorance of the facts and the enormous amount of money spent on (often deceptive) advertising and PR that give investors the false impression that buying this fund or that fund will lead to instant wealth. The media often plays into this nonsense with splashy headlines, designed to sell magazine copies or attract viewers, that promise to reveal which funds or managers are currently the best.

Still, active management can make sense — and that may be especially true when some of the best aspects of active management are brought to the ETF market and some of the best aspects of ETF investing are brought to active management.

Some managers actually do have the ability to “beat the markets,” but they are few and far between, and the increased costs of active management often nullify any and all advantages these market-beaters have. If those costs can be minimized, and if you can find such a manager, you may wind up ahead of the game. Actively managed ETFs cost more than indexed ETFs, but they are cheaper than actively managed mutual funds.

Active management in ETF form may also be both more tax efficient and more transparent than it is in mutual fund form. “Transparent” means you get to see the manager’s secret sauce. Active managers like to keep their secret sauce, well, secret. To date, this has been easier when the wrapper has been a mutual fund, rather than an ETF. However, this may not continue to be the case, as the active managers have already gotten okay from the SEC for partial intransparency and are busy petitioning the SEC to allow yet more smoke.

And finally, with some kinds of investments, such as commodities and micro cap stocks, active management may simply make more sense in certain cases. I talk about these scenarios in Parts 2 and 4.

Why the race is getting harder to measure…and what to do about it

Unfortunately, the old-style “active versus passive” studies that consistently gave passive (index) investing two thumbs up are getting harder and harder to do. What exactly qualifies as an “index” fund anymore, now that many ETFs are set up to track indexes that, in and of themselves, were created to outperform “the market” (traditional indexes)? And whereas index investing once promised a very solid cost saving, some of the newer ETFs, with their newfangled indexes, are charging more than some actively managed funds. Future studies are only likely to become muddier.

Here’s my advice: Give a big benefit of the doubt to index funds as the ones that will serve you the best in the long run. If you want to go with an actively managed fund, follow these guidelines:

• Keep your costs low.
• Don’t believe that a manager can beat the market unless that manager has done so consistently for years, and for reasons that you can understand. (That is, avoid “Madoff” risk!)
• Pick a fund company that you trust.
• Don’t go overboard! Mix an index fund or two in with your active fund(s).
• All things being equal, you may want to choose an ETF over a mutual fund. But the last section of this chapter can help you to determine that. Ready?

Calculating commissions

I talk about commissions when I compare and contrast various brokerage houses in Chapter 3, but I want to give you a heads-up here: You may have to pay a commission every time you buy and sell an ETF. But, as I’m writing these words, another brokerage house may have eliminated commissions altogether.

Trading commissions for stocks and ETFs (it’s the same commission for either) have been dropping faster than the price of desktop computers. What once would have cost you a bundle, now — if you trade online, which you definitely should — is really pin money, perhaps a few dollars a trade, and increasingly, nothing at all. So, unless you are investing a very small amount of money, you needn’t worry about commissions anymore. They are the smallpox of Wall Street.

Moving money in a flash

The fact that ETFs can be traded throughout the day like stocks makes them, unlike mutual funds, fair game for day-traders and institutional wheeler-dealers. For the rest of us common folk, there isn’t much about the way that ETFs are bought and sold that makes them especially valuable. Indeed, the ability to trade throughout the day may make you more apt to do so, perhaps selling or buying on impulse. As I discuss in detail in Chapter 22, impulsive investing, although it can get your endorphins pumping, is generally not a profitable way to proceed.

Understanding tracking error

At times, the return of an ETF may be greater or less than the index it follows. This situation is called tracking error. At times, an ETF may also sell at a price that is a tad higher or lower than what that price should be, given the prices of all the securities held by the ETF. This situation is called selling at a premium (when the price of the ETF rides above the value of the securities) or selling at a discount (when the price of the ETF drops below the value of the securities). Both foreign-stock funds and bond funds are more likely to run off track, either experiencing tracking errors or selling at a premium or discount. But the better funds do not run off track to any alarming degree.

In Chapter 3, I offer a few trading tricks for minimizing “off track” ETF investing, but for now, let me say that it is not something to worry about if you are a buy-and-hold ETF investor — the kind of investor I want you to become.

Making a sometimes tricky choice

Throughout this book, I give you lots of detailed information about how to construct a portfolio that meets your needs. Here, I just want to whet your appetite with a couple of very basic examples of decisions you may be facing.

Say you have a choice between investing in an index mutual fund that charges 0.06 percent a year and an ETF that tracks the same index and charges the same amount. Or, say you are trying to choose between an actively managed mutual fund and an ETF with the very same manager managing the very same kind of investment, with the same costs. What should you invest in?

If your money is in a taxable account, and you’re looking at stock index funds, go with the ETF, provided there are no commissions to pay; it may wind up being more tax efficient. If you’re looking at bond index funds, I’d say this decision is a flip of the coin. Managed funds? Same.

But say you have, oh, $5,000 to invest in your Traditional IRA. (All Traditional IRA money is taxed as income when you withdraw it in retirement, and therefore the tax efficiency of securities held within an IRA isn’t an issue.) In this case, I’d say that the choice between the ETF and the mutual fund is nothing to sweat over. If all else is the same, I’d have a very slight preference for the ETF, if for no other reason than its portability. (See the sidebar, “The index mutual fund trap.”)

And what if your brokerage still charges a commission? Avoid it by going with the mutual fund (provided the mutual fund doesn’t cost you a commission). What if there’s a difference in management fees between the two funds? Say, an ETF charges you a management fee of 0.10 percent a year, and a comparable index mutual fund charges 0.15 percent, but buying and selling the ETF will cost you $5 at either end. Now what should you do?

The math isn’t difficult. The difference between 0.10 and 0.15 (0.05 percent) of $5,000 is $2.50. It will take you two years to recoup your trading fee of $5. If you factor in the cost of selling (another $5), it will take you four years to recoup your trading costs. At that point, the ETF will be your lower-cost tortoise, and the mutual fund your higher-cost hare.

Warning: If you have a trigger finger, and you are the kind of person who is likely to jump to trade every time there’s a blip in the market, you would be well advised to go with mutual funds (that don’t impose short-term redemption fees). You’re less likely to shoot yourself in the foot!