Do ETFs still work in today's market?

November 12, 2008 8:06 PM

For the past year, I have had a general intention to move some of my money out of indexed mutual funds and into the equivalent Exchange Traded Fund. Now I am worried about whether the current financial crisis has undermined the liquidity needed to keep ETFs at their book value.

As I understand it, the difference between an ETF and closed mutual fund is that the ETF has large partners who perform the arbitrage (buying or selling baskets of the underlying securities in exchange for shares of the ETF) so that the price of the ETF stays almost completely in sync with the value of the indexed stocks. (Obviously the value of the ETF has plummeted as the stock market fell - but are they still selling a full book value or have the partners who are supposed to be doing arbitrage failing in their role due to the liquidity and other problems on Wall Street.

In other words, if ETFs made sense for me 3 months ago, do they still make sense now?

posted by metahawk to work & money (6 comments total)

yeah. The only ETF's that are having trouble are the ones that are inverse (short) or leveraged. Also, if they are an ETF on an already illiquid subset of stocks. The ones following major indexes should have no trouble at all.
posted by H. Roark at 8:18 PM on November 12, 2008

If the ETFs are of major indexes you're in better shape. Ditto, if they're managed by well-established blue-chip firms like Lehman Brothers... oh, never mind.

About a year ago I spent a bunch of time trying to figure out how ETFs work. As far as I can tell you have the basic idea: there are key players who put money in and take money out to keep the spreads from getting too large. But that doesn't always work. You can get large spreads, especially when there is a selling frenzy.

The other thing about ETFs is that, as far as I can tell, they actually track their indexes by using various proprietary (i.e. secret) combinations of exotic instruments. They're big black boxes that are supposed to just work because, well, you know, the market always works.

Personally, I prefer mutual funds, which are pretty much transparent. When you buy an SP 500 index, the mutual fund company pretty much buys the stocks in the index and holds them for you.

Given that you can get indexes from Vanguard and Fidelity with annual fees on the order of 10 to 20 basis points (0.1 to 0.2%), what do you gain by going with an ETF? Even if you can save 50 basis points, is that really going to make a difference in the quality of your life when you retire?

It seems to me that if the last six months have taught us anything, it's that simplicity and transparency are really good things to have in financial instruments. I don't think ETFs have those. Maybe I'm an old fashioned luddite, but that's my take.
posted by alms at 8:57 PM on November 12, 2008

I think you meant to say an open-ended indexed mutual fund vs. ETFs. I don't know of any closed-ended index mutual funds.

ETFs are not going to stray too far from their NAV because traders would quickly take advantage of any such spread and arbitrage it away.

You bigger concern should be the bid/ask spread, the same as any stock. Thinly traded ETFs are going to have a bigger spread than higher volume ETFs. You can think of this as an additional fee out of pocket you pay each time you buy or sell the ETF.

The bigger question is why you have decided to switch from open-ended mutual funds to ETFs. There are many advantages and disadvantages to each.

ETFs sometimes have slightly lower expense ratios, but not always. However, you generally lose on the bid/ask spread and also have to pay commissions. If you are moving a big block of money once, then ETFs might turn out better. If you plan to invest small amounts on a regular time interval, mutual funds save you the commissions.

Perhaps you could expand on which funds/ETFs you are considering and why.
posted by JackFlash at 10:11 PM on November 12, 2008

(Disclosure: I've held various ETFs for the past six years, but no mutual funds)

From my own experience, I've been very happy with the ETFs I've held at various times, though my holdings have been limited to index ETFs. I'm not a big fan of actively-managed ETFs (or actively-managed mutual funds, for that matter).

For you, as well as myself, I don't think time is the biggest determinant of whether an ETF is right, but rather its tax efficiency. I haven't had a chance to do this yet, but I've been meaning to create a spreadsheet that compares holding an index mutual fund to holding its equivalent ETF in both taxable and retirement accounts. Perhaps when I get around to it, I'll post it online.

For example, Vanguard's S&P 500 index fund charges about 17 basis points for management fees, while the same Vanguard ETF charges 7 basis points. But, I can add money to the fund for no cost at any time, whereas my brokerage charges 9.99 per trade for the ETF. Index fund dividends can be reinvested automagically, ETF dividends are not. As you can see, there are various trade-offs.
posted by agnielson at 10:21 PM on November 12, 2008

I am a loyal Vanguard customer so I would go with Vanguard ETFs. This is money that I am investing for the long term so I pretty much buy and hold. I would move a large lump sum in and then make occasional additions and a rare sale. The hope is that the expenses would be lower and the capital gains would accumulate untaxed until I eventually sell (instead of being distributed by the mutual fund.)

I did mean closed-end funds - not because they are a real alternative but because I think they have the classic problem of trading for more or less than the under value.
posted by metahawk at 10:38 PM on November 12, 2008

In the case of Vanguard ETFs, they are simply an alternate share class of the regular open-ended mutual fund of the same name. They are managed together as a single fund. The open-ended mutual fund shares will have exactly the same dividend and capital gains distributions and therefore the same tax efficiency as the ETF shares.

The Vanguard ETFs may have a slightly lower expense ratio, about 8 basis points, which will save you about $8 per year for a $10,000 investment.

So if you are sticking with Vanguard, there isn't a lot of difference between the two share classes. Unless you hold your ETF for a very long time, the expense ratio savings are likely to be eaten up by what you lose on the bid/ask spread and commissions. Commissions at the Vanguard brokerage are pretty steep at $25. If you decide to buy Vanguard ETFs and do very many purchases, you may be better off buying them through a discount broker.
posted by JackFlash at 12:36 AM on November 13, 2008