What You Need to Know About ETFs

by
Leo Wealth

We thought it’d be beneficial to take a deep dive into ETFs, into how they’re constructed, how they’re traded, and their risks and benefits. You can enjoy the 40-minute webinar with Aleksey Mironenko, Global Head of Investment Solutions, or you can read an edited version below.

The starting point is how did we get to an ETF? It’s really a story of the evolution of the technology we use to invest. In the U.S., we started with the idea of a mutual fund around 100 years ago. The idea was simple: pool small amounts of money from individual investors into a professionally managed vehicle. The first one was the Massachusetts Investor’s Trust in 1924. At that time, it was all unregulated. It wasn’t  until 1940 that the Investment Company Act was written to regulate mutual funds, and to this day, it is the main piece of legislation that regulates what we do on the investment side. Again, that was 100 years ago, so mutual funds are a hundred-year-old technology. 

In the 1970s, the Samsonite pension fund was struggling to find good people to beat the S&P 500. They asked Wells Fargo in 1971, “can we just buy all the stocks? We’ve noticed that they tend to go up most of the time.” And that entity, which was created for Samsonite, turned into one of the very first passive investments in the world. Jack Bogle saw this and, five years later, created the first retail version. He created the first index fund called the Vanguard First Index Investment Trust. It still exists today.

30 years ago, someone had the idea to take this concept of an index fund and put it on an exchange. The first one was actually not in the U.S. it was in Canada in 1990. The U.S. is never a country to miss a good idea and make it better, so in 1993, the first S&P 500 ETF was launched. And from there, we were off to the races.

Why Does it Matter That an Index Fund is on Exchange? 

The combination of a stock and a mutual fund, or an index fund, is really powerful. Like an index fund, it’s a diversified portfolio. It tracks an index fund. It doesn’t spend a lot of money. It can actually be active or passive. At its heart, it’s a mutual fund, and most of them are passively invested in some specific strategy. But, that’s not the magic. 

The magic is the fact that it’s also a stock. This means, you can buy it at 9:40 AM, or you can buy it at 11:20 AM. You can trade intra-day. There are options available, you can go long or short, and the most important part is that because it’s on an exchange, it’s completely transparent, and that means everybody is competing to “get the trade.” So the execution costs are low, and that matters in terms of generating savings. This combination of a stock and a mutual fund creates instant, efficient, and transparent low-cost exposure, which is why investors like ETFs so much.

Global Industry Growth

Over the last two decades, ETFs have become a $10 trillion U.S. investment tool. It’s growing about 20% a year on average. The only real dips were due to market downturns. There was a dip in 2008, during the financial crisis, and there was a dip in 2018 when there was a year-end correction. Despite markets being down in 2022, half a trillion U.S. dollars has gone into ETFs this year. A lot of it is coming out of mutual funds, but ETFs are still relatively small in comparison. Mutual funds are still six times the size of ETFs. And stocks and bonds are on their own level, together adding up to about $200 trillion. ETFs are still less than 5% of global capital markets. And that’s an important number to remember because oftentimes you hear negative stories about ETFs in the media. A lot of it comes from questions around the entire industry, rather than the industry really dominating the investment landscape. 

ETFs For Nearly Every Asset Class & Style

Even though it’s only $10 trillion compared to the $60 trillion in mutual funds, there are now ETFs for nearly every asset class and investment style imaginable. You can do large, mid, and small equities. You can do U.S., emerging markets, international, or thematics, like moat investing. You can do a very specific sector like oil and gas only, or the semiconductor industry only. In the fixed-income space, you can buy government bonds, inflation-protected bonds, credit, and even high-quality credit. It’s not just about bonds and stocks. You can buy commodities. In the last few years, there have even been crypto funds. 

Even though about three-quarters of the ETF’s market is passive (they follow an index) there are increasingly active ETFs and thematic ETFs. What’s an active ETF? Instead of buying the S&P 500, an active ETF buys the 50 stocks that are the best ideas from an active fund manager, just like a mutual fund. The difference? It’s on an exchange, it’s lower cost to trade, and it’s usually a lower fee and a lower tax bill.

Why Do We Like Using ETFs in Portfolios? 

There are three qualitative reasons and two dollar reasons. Qualitatively, the first one is diversification. I can make one trade and own all 500 stocks in the S&P 500. That’s not that exciting because they’re all listed on the New York Stock Exchange, but I can make one trade and own all two and a half thousand emerging market stocks. From Brazil to Chile, to Indonesia, China, and Poland – in one trade, in U.S. dollars. Second, it’s transparent. Most ETFs are required to disclose every single position every single day. As an investor, I know exactly what I own. I don’t have any worries about a portfolio manager changing their mind. If Apple is in the news, within minutes, I can know how much Apple I own through all my ETFs. And lastly, I can access pretty much any part of global capital markets. 

What about the dollar impact on portfolios? Well, the first thing is they are much more liquid to trade. A mutual fund you can buy once a day, and you don’t know the price at which you buy it. You put in your order, and then at the end of the day, you get told your price. With an ETF, it’s reversed. You trade on exchange, and you can see the price before you hit the buy or sell button. That has massive implications for cost savings. And that’s key. We’re saving on fees, we’re saving on taxes, and we’re saving on transaction costs. 

ETF Savings: Fund Fees

How do ETFs help you keep more of what you earn? First, let’s cover fees. They’re the most visible one. Morningstar published a report a couple of years ago saying, “competition has driven fees to zero in the case of a handful of index mutual funds and ETFs.” Because it’s so transparent, everybody knows everybody’s fee. It is very hard to say that your S&P 500 ETF is better than someone else’s S&P 500 ETF.

The first one launched had a fee of 0.1%. Then another came along and said, we can do a better S&P 500 ETF. They made it not 0.1%, but 0.08%. Then a third schcame along with 0.07%. Three ETFs, all S&P 500, and different prices. Which one do you think gets the most money? Of course, the cheapest one. To respond, competitors keep lowering fees. And the result is transparency. 

If you look at all the mutual funds and all the ETFs in the U.S., the expense ratio difference is half. But that’s equal weighted. In other words, the big ones and the small ones all get the same weight. If you weigh it by assets, it’s basically a fifth. The average ETF in the U.S. costs 0.12%. The average mutual fund costs 0.6%. The math for us as investors is very simple. If I can achieve the same thing, I’m saving half a percent a year. And it’s not just the big ones, the S&P 500. There are over 400 ETFs that charge less than 0.15%. That’s just the sample. The point is that I can pretty much own what I want, and pay away clients’ money a lot less than with a mutual fund.

ETF Savings: Trading on Exchange

The transaction cost savings and the tax savings come from this idea of trading on exchange. It’s important to understand what that actually means. When you buy a mutual fund, you send money to the mutual fund company, the cash goes into the fund, and then the portfolio manager of the fund goes out and buys all the underlying stocks. If you want to sell your mutual fund, The portfolio manager gets a notice that you need $200,000 because you’re selling your position. They will sell whatever it is that they own. Maybe large gap U.S. stocks, maybe emerging market, investment grade corporate bonds. They will sell something to raise $200,000 worth of cash and then send it out to you from the fund.

That’s not how an ETF works. The majority of ETF trading happens between new investors and existing investors. If I want to buy $100,000 worth of a specific S&P 500 ETF,  I will buy it on the New York Stock Exchange, and the person who will sell it to me might be a random buyer. It could be a pension fund. It could be a sovereign wealth fund that happens to own it. It could be anyone. 

The main form of trading is on exchange between existing investors and potential investors, not between the ETF itself. The only time when money goes in and out of the ETF is when there are more buyers than sellers or more sellers than buyers. If there are a lot more buyers than sellers on Tuesday, then there are not enough sellers. Once all the sellers have sold, a broker will take the remaining buys and send them to the ETF, just like a mutual fund. But importantly, because all the positions are known, it’s a hundred percent transparent. It is not the portfolio manager of the ETF who goes out and buys those underlying stocks and bonds. That portfolio manager says to the broker, “you want to buy $200,000 of the ETF directly from me? No problem. Here are the stocks and bonds I need.” Again, it’s all transparent. 

It started as saving time, but now it’s just the way the entire industry works. The broker already knows ahead of time that these are the positions needed. The broker will go out and buy those positions and simply deliver them to the ETF, so the ETF doesn’t buy or doesn’t sell when there is an inflow or outflow. That’s very important for transaction costs and tax implications.

A mutual fund always receives cash and pays out cash. It has to trade inside the fund. It has to generate realized gains or losses. It has to generate transaction costs, but an ETF doesn’t. When money comes in and out, the broker does the trading, and the fees, the costs of that, are charged to the buyer or seller, not to the inside of the fund. And this happens rarely. On average, about $2 to $3 billion a day gets traded on exchange, and very rarely does more than $1 billion go in and out of the fund. This means the ETF doesn’t have to deal with the high costs associated with trading  high-yield bonds. And this has implications for turnover, transaction costs, and capital gains tax. 

ETF Savings: Turnover

A research paper published by the Financial Analyst Journal found that active funds’ annual expenditure on trading costs were comparable in magnitude to the expense ratio, and there is a strong negative relation between aggregate trading cost and performance. In other words, because the active funds are constantly getting cash in or out, they have to trade not because they’ve changed their view but to settle those cash flows. And that’s paid for by everyone in the fund. Looking at the top five mutual funds in the U.S., the average turnover per year is about 20% for the top five. Looking at the top five ETFs, the average turnover is only about 5%. But, that’s the top five. They are the most efficient, and the most well-run, and each inflow-outflow is not as important. 

The larger issue is that an average mutual fund has a turnover of 60%, whereas the average ETF has a turnover of less than 10%. As an investor, I buy a mutual fund and hold it for a year, and I don’t do anything else. Then inside, 60% of my money has been traded on average, either due to active position changes or due to inflows and outflows. 

ETF Savings: Transaction Costs

What is the implication for transaction cost? Because the competition is so transparent, the brokers have started saying you can trade an ETF for free, not a mutual fund, but an ETF.  If you’ve got an account with a broker already, for example, you can trade the 25 ETFs from that broker’s branded ETF for free, but you can also trade 2,000 other ETFs in the U.S. for free. You don’t pay any commissions or transaction costs.

But there are also market costs. You have to pay bid-ask spreads, exchange fees, and so on. How about a comparison of buying an ETF market costs versus buying the underlying stocks? Even with the S&P 500, which is the world’s most liquid 500 stocks, it costs 0.04% to buy those 500 stocks – but it costs only 0.01% to buy the ETF that already owns all of those stocks. As you go to the small-cap market, the international market, or the emerging markets, it gets much more expensive to trade the underlying stocks and bonds. But the ETFs go up from 0.01% to 0.03%. Every time you invest, you are spending less money than the largest institution and the largest mutual funds. 

ETF Savings: Capital Gains Taxes 

This turnover also has big implications for capital gains. The long-term capital gains tax in the U.S. is 23.8%, and the short-term is even higher. Why does this matter? If you buy a mutual fund and you hold it, you shouldn’t be paying any capital gains tax until you sell it. In reality, the IRS requires all funds to pay out any capital gains that are incurred inside the fund within the calendar year, and we can pay taxes on them. An interesting statistic from Morningstar is that in the last five years, 71% of U.S. active equity mutual funds have paid out a capital gain in December. Some ETFs have to pay this out, but remember, an ETF doesn’t do trades inside very often, so the chances are much lower compared to a mutual fund. 

For comparison, 0% of iShares U.S. style box ETFs in the last five years have paid out a capital gains tax. And that’s very powerful. Morningstar estimates over the last 10 years, the average annual cost across the entire mutual fund industry charged 0.87% in fees but incurred 2.09% in capital gains expenses to its investors. In other words, twice the fees. 

The expense ratio, transaction costs, and tax costs all of a sudden are a 4% drag on returns each year. And this adds up. In a somewhat unrealistic marketing piece, BlackRock published a “look how big the effect can be.” They assumed a 15% return for 10 years of a $100,00 investment. At the end, with zero tax costs and just paying the fees and the transactions, you’d have $405,000. But, if you add the tax cost, that’s a $68,000 haircut. It’s a bit unrealistic because 15% returns over a decade per year don’t happen that often. Still, it’s visually clear that there is an explicit tax cost, but it’s not inside the fund. It’s what you pay on April 15, every year if we’re not careful about how we choose mutual funds.

ETF Savings: Capital Gains in 2021

Every year, Morningstar in December publishes a summary of mutual fund, ETF, and U.S. investment vehicle tax implications. They concluded that ETF’s tax efficiency was on display. The number of ETFs that paid out capital gains is much lower than mutual funds. And it makes sense.

If they don’t have to trade inside the ETF, they realize fewer gains and losses. Out of 1600 ETFs that they reviewed, only 140 had realized gains, and only 34 had realized gains over 1%. On the mutual fund side, 600 funds had realized gains of over 10%, and 100 funds had realized gains of over 20%. The average gains were 9%, and 6%, depending on the asset costs. That 9%, means you are paying 23.8% on 9% of the holding in tax. That’s the savings part. Fees are usually lower, transaction costs are usually lower, and the tax bill is usually lower for ETFs. But that’s one of the reasons we are increasingly using more ETFs in our portfolios. 

Allocation Drives Returns 

One of the main reasons that ETFs are becoming more popular is that it’s very easy to asset allocate. Why asset allocate, as opposed to picking between Pepsi and Coca-Cola? In 2014 a very large study was done trying to break apart the returns of a pension fund into asset allocation, style tilt, and stock fix. And this is what they found.

99.3% of the return came from the choice of exposure. Do you own U.S., or do you own Europe? Do you own large caps, or do you own small caps? Do you own stocks or bonds? 0.4% of the return came from what they called “factor risk premium.” This is basically value versus growth, high quality versus poor quality, and momentum versus mean return. 0.3% came from stock picking and bond picking to get you to the total of the fund return. For that fund, because it’s so large, the number one decision is what broad asset allocation they have. Not which stock or bond. And that’s exactly how we use ETFs. 

ETF Use Cases

There are basically two uses. The first is core exposure. I want to own a broad market as low cost, as liquid, and as efficient as possible. We can own emerging markets, developed, U.S., U.S. value, and U.S. growth. The less we spend to own it, the better the outcome.

The second use is to tilt the portfolio thematically and tactically, to where we see opportunity. It’s not about timing the market, it’s about timing in the right parts of the market. Owning financials, when rates are going up, owning quality and safe names when we are on the path to a recession. Owning high yield and emerging market bonds when things are safe, owning treasuries when things are less safe. We can do all of this through an ETF. And because it’s so low-cost to trade, we can do it a little bit more tactically than we can with mutual funds. The ETF portfolios we run for example, range from 100%  stocks to 100% bonds. That has implications for the returns and volatilities over the long run, but the premise is simple: keep costs low, keep tax impact low, allocate to macro trends, and be in the right parts of the market. Don’t try to time the market and trade every single week or every single month, and make sure that you always know what you own and that you can get out when you need to, either due to client reasons or market reasons.

ETF Example: U.S. Focused Equity

A portfolio entirely of ETFs, over the long run, outperforms the average active fund that has more than 85% in equities. But in terms of positions, this is what the positions look like today. It’s 10 ETFs, two core positions, four style positions, and five thematic positions. The average fee that we pay away is only 0.15%. Turnover over the last year has been 12%, and in terms of capital gains, zero so far paid out in the last 12 months. If you go back to the last five years, the answer would still be zero.

We’ve got a position in commodities, we’ve got a position in emerging markets, ex state-owned, and government-related names. What might jump is that we have 62% in one position. That might feel like a lot to put in terms of concentration risk. But remember, this isn’t an active fund. We know exactly what we own. The 62% comprises 1,505 stocks and it has a fee of only 0.09%. We see a lot of portfolios from new clients who come to us where they’ve got six different positions, 10% each, and that looks more diversified. But when we look through those mutual funds, what we find is there are 400 positions in those six funds. They’re less diversified than this one line, and the average fee is 0.3% or 0.4% instead of 0.09, and the capital gains paid out were 2-3% last year. It’s a concentrated position, but remember, I can sell it immediately. It’s liquid. It’s very diversified, and it’s very efficient.

What Are The ETF Misconceptions? 

A common misconception is that ETFs are dangerous because they’re passive, they’re not capitalists, or it’s un-American. It’s an easy thing to pick on because it’s growing so fast. It’s very visible, but in fact, almost all pension funds do passive investing, and there’s actually nothing passive about it. The biggest users of ETFs are active asset allocators and investors like us. We don’t permanently hold ETFs. We’re building a portfolio that we want to see. 

Another is that ETFs haven’t proven their liquidity metal yet, even after being around for three decades, including the financial crisis. One answer to that is very simple. With the mutual fund, you have to put in cash and take cash out. They have to buy and sell the same stocks. In ETFs, you have two doors. I can trade on an exchange with a buyer. Or, if there are no buyers , then yes I go to effectively the mutual fund version of the ETF. 

ETFs are also thought to underperform, because it should be the index return minus the fee. In reality, you have taxes, you have transaction costs. And you have thematic active ETFs that often do better. 

For the misconception that ETFs don’t work in inefficient markets, it’s true that in less efficient markets, it’s actually easier for active managers to outperform. But remember, in less efficient markets, it costs much more to trade as well. If you can avoid those transaction costs, you might end up being better. 

ETFs aren’t always cheap. Some ETFs can, in fact, get quite expensive. The providers are for-profit enterprises, often the same ones that are making the mutual funds. 

And last, all ETFs are all the same. They’re similar, but three different S&P 500 ETFs can have three different return streams because of the way they copied the S&P 500. 

What Are The ETF Risks? 

There are now leveraged and inverse ETFs. Where investors oftentimes misunderstand exactly how they work. And these can get very volatile and can lead to very surprising outcomes. 

Liquid doesn’t mean easy to trade. Just because you can always trade an ETF doesn’t mean you can trade it at a good price. You have to pay attention to how you trade. 

There are a lot of thematic ETFs, for example, the label might say semiconductor ETF. But how they define what is a semiconductor technology company is different, and they all end up having completely different holdings. You still have to do your homework as an investor. You have to look inside, you have to understand the design. 

Some of the simpler ETFs can be taken advantage of. A famous example was an S&P 500 inclusion of Tesla. A lot of active investors bought it before it got included in the S&P 500 index, and then the S&P 500 ETF buys it once it’s included at a higher price. There are things that good ETF managers do to avoid this. But it’s a risk with smaller ETFs. 

If too much of the investment universe becomes passive, then volatility will increase. But as mentioned earlier, only 5% of the global equity and fixed-income markets are ETFs today.

As with everything, when you do things on your own, you need to do your homework. And if you don’t, things can go a bit wrong. But that’s true for ETFs, that’s true for mutual funds, and that’s true for anything else. 

ETFs: A Conclusion

To conclude, ETFs provide diversification, transparency, market access, and liquidity. The transparency plus liquidity means lower management fees, lower turnover and transaction costs, and lower capital gain taxes. We use ETFs across the board for core long-term exposures for thematic and tactical exposures. Increasingly we are seeing active mutual funds being turned into active ETFs simply because the technology is more efficient. You can trade on your phones, you can trade with many different types of investors. We suspect in 10 to 15 years, more and more active funds will become ETFs. 


DISCLAIMERS & DISCLOSURES

The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to the accuracy, completeness, or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market.  They are methods used to help manage investment risk.

Active portfolio management, including market timing, can subject longer term investors to potentially higher fees and can have a negative effect on the long-term performance due to the transaction costs of the short-term trading. In addition, there may be potential tax consequences from these strategies.  Active portfolio management and market timing may be unsuitable for some investors depending on their specific investment objectives and financial position. Active portfolio management does not guarantee a profit or protect against a loss in a declining market.

Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not generally backed or supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional currencies. Cryptocurrencies are not covered by either FDIC or SIPC insurance. Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of cryptocurrency. 

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value-weighted index with each stock’s weight in the index proportionate to its market value.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

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