Saturday, August 18, 2007

Exchange Traded Funds

Do you have a largish sum of money that you need to invest wisely? Maybe your start-up just got acquired or (better still) went public. Or maybe you just reached the 1 year cliff on your options vesting. Or maybe you switched jobs and you've rolled over your 401k into an IRA at a brokerage firm. Or maybe you inherited some money from a rich uncle.

Whatever the source of the money, are you now faced with the problem of how to invest it wisely? Maybe you've decided against picking your own stocks because you're concerned about risking your nest-egg on a high-flier like AAPL (betting that the iPhone will take Apple to new heights...) or on a beaten down stock like PALM (thinking that it's undervalued because the Treo will make a dramatic comeback...). And maybe you're concerned that paying a financial advisor 0.5%-1.0% of your assets annually is too high a cost for unclear benefits. Maybe you want to invest in mutual funds, but you're not sure which ones to invest in.

Well I have a suggestion for you: invest in a portfolio of Exchange Traded Funds (ETFs). Seeking Alpha has a really great and comprehensive guide to ETFs. But before you read that guide, here's a short summary of the highlights. I'll try and explain what they are, why they're good, when you should avoid them, and a sample portfolio that we use. (Caveat: I'm not a financial advisor. Nor do I have any formal investment background. So you should take everything in this post as my personal opinion only.)

What are ETFs

ETFs are like index mutual funds in that shares in an ETF represent ownership in an underlying basket of securities that track some index (e.g., the S&P 500 index). However, unlike a mutual fund, small retail investors cannot buy (sell) shares directly from (to) the Fund company. Rather, such investors can trade ETF shares with other investors on a stock exchange. One consequence of this is that ETF shares can be traded throughout the day, rather than just at the end of the day like mutual funds.

How do ETFs work

A second consequence of trading ETF shares on a stock exchange is that shares can trade at a premium or a discount to the net asset value (NAV) of the underlying securities. However, as a practical matter, ETF shares trade at prices close to the NAV. Here's why. ETF shares can be exchanged with the Fund company for a basket of the underlying securities. These in-kind exchanges are allowed only for bundles of a large number of shares, typically 100,000 shares. This means that the only entities likely to make such exchanges are large institutions.

So now imagine that ETF shares are trading at a premium to NAV on the stock exchange. A large institution, wanting to profit from this premium, will give the Fund company a basket of securities representing the index (priced at the NAV) and get an equivalent number of ETF shares (priced at the premium). They can now profit by selling these ETF shares on the stock market. But by selling these ETF shares, they drive down the price of the ETF toward the NAV.

The opposite happens if ETF shares are trading at a discount to NAV. The large institution will buy ETF shares (priced at the discount) on the stock market and return them to the Fund company, getting back the basket of securities (priced at the NAV), thus making a profit. But by buying these ETF shares, they drive the price of the ETF up toward the NAV.

The net effect of all of this is that the price of an ETF usually stays very close to the NAV.


With mutual funds, when other investors redeem shares, the Fund may have to liquidate some of the underlying securities to fund the redemption. This can generate capital gains, which are shared proportionally by all investors in the Fund. Thus you can incur capital gains when someone else redeems shares.

This doesn't happen with ETFs. Since all exchanges with the Fund are in-kind, the Fund incurs no capital gains as a result of exchanges. When retail investors sell ETF shares, there's no change in the Fund's holdings of the underlying securities. So, once again, the Fund incurs no capital gains. Thus, investors in the fund incur no capital gains when others sell or exchange shares.

The only way fund investors incur capital gains is if the underlying index changes (so the Fund has to sell some securities and buy others to come in line with the index), or if investors themselves sell ETF shares. As with mutual funds, investors get their proportional share of interest and/or dividends thrown off by the underlying securities.


Since ETFs are essentially index funds, one of their big advantages is low costs. A typical ETF following a major index may have costs under 0.2%. This is in contrast to an actively managed stock mutual fund that may have costs in excess of 1.0%.
(Note that there has been a proliferation of specialized ETFs following sectors or small sections of the market and these might have higher costs.) ETF costs are usually deducted directly from the interest and dividends thrown off by the underlying securities.

One cautionary note on ETF costs: since ETF shares are traded on the stock exchange, they do incur trading costs. Thus, to keep these trading costs low, you need to trade a significant amount. For example, suppose that your discount broker offers trades at $10 per trade. If you now buy ETF shares worth $1,000, then the trading costs are 1.0%. That really works against the low cost advantage of ETFs. To keep the low cost advantage, you'll need to trade larger amounts, e.g., at least $5,000 for a 0.2% cost. The main consequence of this limitation is that ETFs are not a good vehicle for dollar cost averaging over a period of time by, say, investing $500 per month. This is the reason for the introduction to this post where I talk about having a largish sum to invest.

ETF Portfolios

By now you're probably thinking, "Okay, okay, you've convinced me that ETFs are great. But which ones should I invest in?" The ETF guide I linked to above suggests a core portfolio consisting of 10 funds and a low-maintenance portfolio consisting of only 5 funds.

We've been using a different portfolio consisting of 13 funds. It is one of the portfolios originally recommended by Burton Malkiel, professor of Economics at Princeton and author of the classic investment book A Random Walk Down Wall Street. I heard a talk by Malkiel about 2 years ago in which he extolled the virtues of ETFs and suggested four different ETF portfolios for different levels of risk. You can find these four portfolios here. (Caveat: These were recommended 2 years ago, and there's no reason to believe Malkiel hasn't changed his recommendations since then.)

I don't want to imply that these portfolios are the best available. But I will say that you could do a lot worse by following some active management strategy (unless you really know what you're doing). Following one of these portfolios allows you the comfort of knowing that you're going to do pretty well, probably better than a majority of investors, with almost no effort at all. And no stress either: whether the stock market is up or down, your investment strategy doesn't change.

One other thing that Malkiel mentioned is to rebalance the portfolio once a year. The idea is some ETFs may do much better than others and may grow to take on a disproportionate share of your portfolio. You then sell some of that fund and buy funds that haven't performed as well. Of course, you need to do this carefully because rebalancing always incurs costs.


Ashish said...

Excellent post - I will be downloading all those links and reading up on these nifty iftys.

(Except, they are itfy's? - do they have a cute pronunciation?)


Sushrut Karanjkar said...

Excellent article. Very informative.

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