LEVEL: BEGINNER
Advantages and Disadvantages of ETFs over Mutual Funds
For traders on the Zolio platform, ETFs are an extremely valuable financial tool because they can be traded like stocks during the day, but they allow traders to invest in non-equity markets, such as government bonds, fixed income, commodities, and so on.
While this is one of the greatest advantages to ETFs for you, there are other advantages and disadvantages to investing in ETFs versus other types of funds, particularly mutual funds, which you should be aware of. While both types of funds exist to serve the same function—namely, to give investors an opportunity to pool funds and make more diversified bets than investing in a single asset or equity—they function very different due to their structures and market positionality. Here are some of the key differences between ETFs and mutual funds that you should be aware of.
Tradability
Mutual funds cannot be bought and sold during a day’s trading. If you want to invest in a mutual fund, you can only buy an interest in a fund at the end of the trading day, when mutual fund values are re-assessed.
ETFs, on the other hand, can be bought and sold during the normal trading day and during extended hours, so you can buy into an ETF at 11:30am on a Wednesday when the exchange is open, if you so choose. This means that ETFs can be bought and sold intraday as well as over the course of several trading days, meaning that they can be a vehicle for a short-term speculative investment—and if you decide to liquidate for whatever reason (new information becomes available, your portfolio strategy changes, or you want cash in hand to buy another asset), you can sell the ETF immediately.
The tradability of ETFs means that their price is more variable than mutual funds, whose value is recalculated at the end of every trading day. The market determines the value of ETFs, but mechanisms in place usually insure that the ETF’s market price closely tracks its net asset value (NAV). While there are times when these two vary greatly, this is unusual and often a warning sign for a particular ETF. When ETFs have a large discrepency between their market value and NAV, that usually means that the fund is not traded often enough or there is reason to believe that the fund is mismanaged.
Volume and Markets
The market for mutual funds is several times greater than ETFs; while a few thousand ETFs exist on the market, many more mutual funds exist. The mutual fund market is also much older. This means that traders have a wider variety of mutual funds to choose from, and these funds usually have a longer performance track record. In terms of sheer volume of funds, mutual funds win out by a long shot.
However, mutual funds were created so that people would not trade them very often. They are for long-term investing and not short-term speculation, so, at least in theory, mutual funds will not be bought and sold as much in a day as comparable ETFs.
In practice, the ETF market is many times smaller than mutual funds, although ETFs are growing considerably and more and more money is flowing to ETFs as more investors become aware of them. This trend is sure to continue, but for now this means that ETFs will have less intraday trading volume than stocks or the total amount of shares bought and sold at the end of the day for mutual funds. This is a serious concern; a lack of volume means a lack of liquidity, which means placing an order will place the sort of pressure on an investment that you do not want to have. In the worst case scenario, if you have invested in a particularly exotic ETF and there is no demand to buy, you might find it impossible to sell your shares when you want to, even if you lower your ask price.
Variety
Mutual funds, by their nature, try to be conservative, but they also try to integrate the talent of the fund’s management to maximize returns. Some funds are more successful than this, which has resulted in a large bredth of different funds to choose from. However, due to their conservative nature, they tend to invest in less exotic assets. There is no mutual fund that tracks the VIX, for example. While most mutual funds will invest in stocks, bonds, metals, and energy commodities, ETFs will invest in more exotic things, such as derivatives, options, and futures contracts. There are also more ETFs focused on emerging markets and emerging technologies. For example, while there is an ETF focused on social media companies (the Global X Social Media Index ETF, SOCL), there is no similar mutual fund for this highly specialized and new sector—although there are a lot of mutual funds that will invest in social media companies.
Visibility
Another advantage to ETFs over mutual funds is the level of visibility that investors have into the inner workings of the fund and its holdings. ETFs are required to announce their holdings frequently, and you can research what these holdings are with several online tools, such as www.etfdb.com. Better yet, ETFs will also list their holdings on their websites, and this is updated daily. For instance, if you go to SOCL’s website (http://www.globalxfunds.com/SOCL), you can see that which companies the fund has invested most of its money into. On October 9th, the fund had 12.19% of its assets in Chinese social media firm Tencent and 11.93% in LinkedIn, as well as smaller shares in Sina Corp, Dena, Google, Yandex, Facebook, Mail.ru, Netease.com, and Nexon.
This is much greater, in-depth information than I can get with a mutual fund, meaning that I know what I am buying much more easily than I can know with a mutual fund.
Cost
Another advantage to ETFs is that they are lower cost—an attractive point for any investor, especially long-term investors worrying about how much of their money is going into the fund managers’ pockets. While mutual funds tend to have expense ratios between 1% and 2% for more exotic types of assets, ETFs can often have lower expense ratios, going as low as 0.40% and below for some mainstream index-tracking funds like the S&P 500 SPDR (SPY), which has an expense ratio of just 0.09%.
ETFs also have no loads and no minimum buys, which makes them a more attractive buy for investors looking at dollar cost averaging. However, this may be a Trojan horse for some investors, since the commissions they pay on ETFs is much higher than what the loads and fees of a similar mutual fund would cost them. This is why it’s important for investors to calculate their costs before choosing one or the other.
In the real world, most investors will have a mix of ETFs and mutual funds, choosing the one product type over the other when it most benefits them. For Zolio, however, you will be limited to ETFs but you should be aware of how these relate to mutual funds, since any portfolio manager should be ready to explain to clients how both products differ.
Index Funds and ETF Market Efficiencies
As noted above, ETFs tend to trade at or near their NAV, thanks to market mechanisms that ensure that the mix of supply and demand for the ETFs automatically resets the value of the fund’s underlying holdings. With mutual funds, there is no such market mechanism, but there’s no need for one—investors only pay a portion of the fund’s NAV, which is always identical to the cost of an interest in the mutual fund.
One easy way to gauge an ETF’s health is to look at the history of its NAV and market cap, and to compare these two. If the fund has consistently a small premium or discount (in this case, a premium or discount below 0.25% would be small), then the fund has a history of being actively traded and resetting to around its value. This is a particularly important metric when it comes to leveraged ETFs, since they may suffer the effects of fund decay due to the diminishing yields from leveraged funds.
These gaps between an ETFs real value and the amount that it is trading for are typically more pronounced in more exotic ETFs, whereas indexed ETFs such as SPY, which I consider the grandfather of the ETF market, will generally trade at premiums or discounts of less than a tenth of a percent at any time.
For this reason, ETFs are an ideal option for investors who want to invest in an index. If you believe the S&P 500 is going to go up, you can invest in a mutual fund that tracks the S&P 500 (there are many), or you can buy SPY, IVV, or VOO, all of which do the same thing at a lower cost. VOO is one of the most inexpensive ETFs on the planet, with an expense ratio of just 0.05%. There is no cheaper way to invest in the entirety of the S&P 500.
Conclusions
Any investor who wants to buy into a particular market needs to seriously consider ETFs as an option. For investors on the Zolio platform, they are a valuable method of diversifying quickly, and easily.
The up side of diversification by ETFs is that your risk/reward profile is lower, meaning there is less chance you will lose money. But it also means that your chance of making a lot of money is lower, too. No portfolio manager can keep his or her holdings solely in ETFs, but a portfolio manager can augment an already diversified portfolio with ETFs to make specific plays that would be too costly, time consuming, or difficult to do otherwise. So too should you look at ETFs as a way to augment your trading strategy.