ETFs are the next generation of passive index funds

Some ETF providers have cited strong cash flow as proof the product is a great improvement over mutual funds. Critics, however, have raised concerns that ETFs may carry more risks than mutual funds. Neither statement is entirely true. ETFs are governed by the same regulations that govern other types of mutual funds and carry similar risks and benefits.

The real story

The real story behind the growth of ETFs is the increasing popularity of the index approach. Institutions have long adopted indexing, and it’s now winning converts among financial intermediaries, like advisors who traditionally favoured individual stocks, separate accounts, and actively managed mutual funds. ETFs offer an accessible and flexible way for this constituency to index.

The primary appeal of ETFs is based on their index characteristics—low costs, broad diversification, tax efficiency, and relative performance predictability. ETFs are similar to traditional index funds in that they both comprise a collection of securities that represent an underlying benchmark.

For example, a MSCI Canada ETF is a collection of all the securities that make up the Morgan Stanley Canada Index. ETFs tracking other market segments, such as emerging markets, bonds, or U.S. stocks, also follow specific benchmarks. With ETFs that purchase stocks or bonds to replicate their index, the risks are similar to those in traditional index funds: market risk and tracking risk (i.e., the risk that the fund or ETF won’t closely track its index).

Less common in Canada are the ETFs using a synthetic structure, where exposure to the market is gained through a swap contract, instead of buying actual stocks or bonds.This type of ETF structure can carry some additional risks, including counterparty exposure and collateral risk.

Yet, whether invested in physical assets or swaps, the aim of the ETF is the same—to match the performance of an index.

Not all ETF providers—or index fund providers—are equally successful at tightly tracking a benchmark.

Regardless of whether an ETF uses physical assets or swaps, where ETFs truly differ from traditional index funds is in how they are priced. A mutual fund is priced at the end of the day, and can usually be purchased from a mutual fund company. ETFs are priced and traded throughout the day on a brokerage platform.

The long and short of it

Although the liquidity and trading flexibility of ETFs may appear most suitable for short-term portfolio management tactics, our experience is that advisors use ETFs for longer-term exposure to broad market segments, especially when traditional index funds may not be accessible on the advisor’s platform.

Of course, ETFs can be used for short-term portfolio management tactics when appropriate. For example, an advisor may under or overweight market segments or industry sectors using ETFs based on evaluating market mispricings.

An advisor who believes smallcap stocks tend to outperform when the economy comes out of a recession could overweight a small-cap ETF during such periods. Hedge funds, for example, frequently use ETFs as vehicles for speculative bets on a market’s returns or the returns of a particular segment of the market—either by taking a pure long position or a pure short position.

Finally, this trading flexibility can benefit clients making the transition from another advisor or otherwise selling investments as part of a change in portfolio strategy. ETFs can reduce “cash drag” until the assets can be appropriately reinvested.

ETFs versus mutual funds

An ETF typically has a lower expense ratio than a comparable mutual fund, but there are other costs to consider.

As with the purchase of stocks, investors who buy ETFs incur a bid-ask spread, which is defined as the difference in the market price to buy the ETF and the market price to sell the ETF.

The bid-ask spread is highly dependent on the liquidity in the market, the breadth of the underlying index, and the daily happenings in the marketplace. There may also be brokerage commissions associated with buying or selling the ETF, as with any stock.

Investors must do a little math to determine which makes the most sense based on their planned holding period—an ETF with trading costs and a lower expense ratio, or a fund with a higher expense ratio and no trading costs.

For most long-term investors, the savings from an ETF’s lower expense ratio will outweigh the one-time trading cost of buying the ETF.

For short-term investors, an expense ratio is less important. There is a break-even point that must be considered (see “Impact of long-term and short-term holdings,” below).

For investors seeking to use indexing as a portfolio building block, they must decide between funds and ETFs by comparing products to find those with the lowest total cost, best-constructed benchmark for any given market segment, and the best history of tightly tracking that benchmark.

There’s also some criticism of ETFs being riskier than traditional index funds. That paints the ETF category with a broad brush, and perfectly sensible and well-structured ETFs are facing reputational risk due to complex or niche products not performing as expected.

Complex and non-diversified products may indeed deserve extra scrutiny and better understanding to ensure they meet the intended needs of clients.

Any investment should meet a sound, enduring, long-term investment need. Some niche ETFs don’t meet that test. That being said, this is not solely an ETF issue: many traditional mutual funds also fail this test.

Education is key in ensuring investors understand the risks and differences between the many types of ETFs, mutual funds or other investments.