An old business school case study tells the story of how the benefits of the telephone over the telegraph were not appreciated at the time that the telephone was invented. It’s hard to believe, but Western Union (NYSE: WU ), the dominant U.S. telegraph company, thought the best use of this new invention would be to link telegraph offices and have operators read telegraphs to each other over the telephone. They turned down an offer to acquire the full patent from Alexander Graham Bell for $100,000, $2mm inflation adjusted today, putting them in the running for worst business decision of all time. Twenty-five years after the arrival of the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), the fund that got things rolling, I think many experts are showing a similar lack of foresight when they view the ETF as an innovation offering little benefit over traditional mutual funds. Investors do see their merits (at Elm Partners we use ETFs extensively), pushing assets invested in ETFs through the $3 trillion milestone, with SPY, the largest ETF, at close to $200bb of market cap. 1 Click to enlarge Often cited advantages of ETFs like SPY are that they can be easily traded continuously all day, options markets form around them, and they are easily marginable, allowing the active investor to raise cash when needed for other investments. At Elm Partners, we invest on an unleveraged basis, with a long-term horizon (see my recent Seeking Alpha note on expected long-term real equity returns ), and we believe that ETFs have at least three less publicized advantages for long-term investors like us: Tax efficiency, Lower cost, and Insulation of long-term holders from the trading costs induced by investor turnover. Jack Bogle and Larry Fink, the founders of the two biggest ETF sponsors, argue that many of the nearly 6,000 available ETFs do not have the desirable features we should expect from passive, index oriented products– such as low cost, diversification, transparency and simplicity — and I agree that it does make sense to avoid ETFs with labels such as “synthetic,” “actively managed,” “leveraged” and “inverse.” However, I disagree with Bogle when he states that ETFs are “just great big gambling, speculative instruments that have definitely de-stabilized the market.” 2 To the contrary, I believe the ETF structure is a source of financial stability, and is better for long-term investors, as compared to traditional mutual funds. Here’s why. Tax efficiency: First, taxes matter a lot to the long term return investors earn. ETFs like SPY are much more tax efficient than typical open ended mutual funds. 3 U.S. mutual fund tax accounting means that realized capital gains triggered by redemptions are allocated to all investors who hold the fund at year end, even though those remaining were not responsible for causing the capital gain. The tax basis of their holding will be increased, so there won’t be a double counting of capital gains, but the acceleration of their tax liability and the potential of being allocated higher-taxed short-term capital gains is unpleasant, and unfair. With ETFs, redemptions do not trigger sales that generate capital gains. Instead they cause the fund manager to deliver a basket of the underlying fund assets to the Authorized Participant who in turn gives shares of the ETF to the fund manager for redemption. The tax efficiency can be further enhanced by the fund manager delivering the lowest basis tax lots held inside the fund to the Authorized Participant. The ETF tax advantage, over a long term horizon, can be worth as much as an extra 0.5% of annual return on an after-tax basis for U.S. taxable investors. 4 Cost efficiency: Second, ETFs are typically cheaper to run than mutual funds, and this cost saving tends to get passed on to investors. ETFs usually have lower marketing, distribution, accounting and administration (including KYC and AML) expenses. This probably explains why Vanguard charges higher fees on its mutual funds than it does on its ETFs. 5 Investing in an ETF does involve paying the bid-offer spread, although for SPY that amounts to less than 0.005%, and for small trades, that can be more than offset by the low commissions on ETFs as compared to mutual fund trade charges (roughly $9 vs $30 respectively, at many brokers). There’s the risk that the price of the ETF declines in relation to NAV, but for long term investors this is less of an issue, and may even present an opportunity. Insulating long-term investors from transactions costs of subscriptions/redemptions : In a traditional mutual fund, the costs of having to buy or sell securities to accommodate incoming or departing shareholders are borne by the investors who remain in the fund, rather than by the investors who trigger those costs. In normal times, these costs can add up to as much as 0.10% of extra annual cost for long term mutual fund investors. 6 For the case of SPY, the cost difference would be less than 0.10% in normal times, but for funds investing in less liquid underlying assets– such as the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ), the iShares Russell 2000 ETF (NYSEARCA: IWM ), the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ), and the iShares National AMT-Free Muni Bond ETF (NYSEARCA: MUB )– or with indexes that are quite dynamic– such as the iShares Select Dividend ETF (NYSEARCA: DVY ), the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ), the iShares U.S. Real Estate ETF (NYSEARCA: IYR ), the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA )– ETFs can provide substantial cost savings. Particularly in times of crisis this flawed design feature is exploited by sophisticated investors who make a concerted rush for the exit, so that they can get out at the mid-market net asset value, NAV, price, leaving the remaining investors to bear the heavy cost of the liquidations the leavers instigated. Regulators have been expressing their concern about this a lot lately. By contrast, in an ETF competing brokers create and redeem ETF shares in exchange for the basket of individual securities that comprise the ETF. 7 No trades take place, and hence no costs are incurred inside the ETF as investors enter or exit. Existing ETF investors are thereby insulated from the costs of buying or selling securities to accommodate subscriptions and redemptions. Click to enlarge In turbulent times, this mechanism protects long-term investors while accommodating investors who want to exit at a fair, non-subsidized price. True, an ETF which is based on underlying assets that are not very liquid, such as high yield bonds, can give investors a false sense of liquidity. If many holders want to sell, not only will the price of the asset class fall dramatically, but the arbitrage mechanism will not stop the price of the ETF going to a substantial discount to NAV, and even to a discount to the bid side of the underlying assets. While this isn’t a pleasant scenario for the holder of that ETF, it is better than what happens with an open-ended mutual fund structure. With ETFs there is no incentive for investors to be first out the door, as each investor bears her own marginal cost of increasing or decreasing the fund size. Click to enlarge Furthermore, direct trades in the ETF between buyer and seller can bypass the basket entirely. This is referred to as the ETF ‘liquidity layer,’ which can lead to an ETF trading at a much tighter bid-offer spread than the underlying market, further reducing the total cost of investor turnover. So where does this leave us? Perhaps the most broadly voiced criticism of ETFs remains so far unanswered: that they tempt investors to become active, short term traders, which has been shown to cost investors a lot in the long term. Jack Bogle is joined by Warren Buffett, the Bank of England’s Andrew Haldane and many others on this one. Responding to their founder’s concerns, the researchers at Vanguard wrote a report, aptly titled, “ETFs: For the Better or the Bettor?” (July 2012). While we’d like to see all investors succeed (at Elm Partners we are not engaged in zero sum investment management), we agree with the Vanguard researchers’ conclusion that the temptation effect “is not a reason for long-term individual investors to avoid using appropriate ETF investments as part of a diversified investment portfolio.” So, whether your horizon is short term or long term, ETFs like SPY have significant benefits over their traditional mutual fund cousins. Notes: Globally, including ETPs, according to www.ETFGI.com . For simplicity in this note, we’ll use the term ETF to include ETPs in terms of overall marketplace description. Zweig, 2011. Just to be clear, I am not offering tax advice. Please consult your tax advisor. Based on a 24.4% effective marginal tax rate for long-term capital gains, a 3% dividend yield and long-term growth of 3.5% pa. This is generally the case for Vanguard’s U.S. listed Investor shares vs ETFs, and also the case for their Irish listed fund and ETF products. For example, for a fund with 50% annual unmatched investor turnover (which can include net subscriptions), and underlying assets with a 0.20% average bid-ask spread. The sponsor can also accept cash or partial baskets, and if the sponsor is not careful, some of the costs can slip into the ETF. Generally, we’ve found that for the biggest ETF sponsors, they are very careful. Also, we should mention that many of Vanguard’s U.S. listed ETFs are a hybrid structure, which has features of both a mutual fund and an ETF. A detailed treatment of this hybrid structure is beyond the scope of this short note. Disclosure: I am/we are long SPY, HYG, MUB, EEM, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This article should be construed as tax, or investment advice.
