In fact, you could do all your investing with the 1,000 or so ETFs, most of which use index-style strategies rather than active management. It's very easy, taking just a few clicks of a mouse with your online-broker—just like trading a stock. Fees are extraordinarily low, and ETFs can be very kind come tax time.
So why not buy a few ETFs and let it go at that?
Many financial advisors indeed like ETFs, but caution they are not perfect for all occasions.
Like mutual funds, ETFs pool investor assets and buy stocks or bonds according to a basic strategy spelled out when the ETF is created. But ETFs trade just like stocks, and you can buy or sell anytime during the trading day. Mutual funds are bought or sold at the end of the day, at the price, or net asset value (NAV), determined by the closing prices of the stocks or bonds owned by the fund.
Because they trade like stocks, ETFs can be sold short, a way of profiting if the ETF price drops instead of rises. And many ETFs have related options contracts, which allow investors to control large numbers of shares with less money than if they owned the shares outright. Short selling and options are not available with mutual funds.
This difference makes ETFs better for day-traders betting on short-term price changes of entire market sectors. For long-term investors, these features don't matter.
Most ETFs are index-style investments, similar to index mutual funds. That means the ETF simply buys and holds the stocks or bonds in a market gauge like theStandard & Poor's 500 stock index or Dow Jones Industrial Average. Investors therefore know what securities their fund holds, and they enjoy returns matching those of the underlying index. If the S&P 500 goes up 10 percent, your SPDR S&P 500 Index ETF (SPY) will go up 10 percent, less a small fee. Many investors like index products because they are not dependent on the talents of a fund manager who might lose his touch, retire or quit.
While the vast majority of ETFs are index investments, mutual funds come in both flavors, indexed and actively managed, which employ analysts and managers to hunt for stocks or bonds that will generate alpha—return in excess of a standard performance benchmark.
So investors really face two issues: Should they choose actively managed funds over indexed products? If they prefer indexed ones, are ETFs preferable to mutual funds?
Active Management
Many studies have shown that over time, most active managers fail to beat their comparable index funds and ETFs, because picking market-beating investments is very hard. Also, managed funds must charge larger fees, or "expense ratios," to pay for all that work. Many managed funds have annual charges as high as 1.3 percent to 1.5 percent of assets in the fund. In contrast, the Vanguard 500 Index Fund (VFINX), a mutual fund, charges just 0.17 percent. And the SPDR S&P 500 Index ETF just 0.09 percent.
"Over the long term, taking into consideration costs and taxes, active management does not outperform indexed products," said Russell D. Francis, an advisor with Portland Fixed Income Specialists in Beaverton, Ore.
Active management is worth paying for only if returns (which account for the fees) beat those of the comparable index products. And the investor must be convinced the active manager won through skill, not luck.
"A simple way to answer this question is to look at the managers' track record," said Matthew Reiner, a financial advisor with Capital Investment Advisors of Atlanta. "Have they continuously been able to outperform the index? Not just over one year, but three, five, 10 years?"
In looking at that track record, be sure the long-term average has not been skewed by just one or two extraordinary years, as spikes are often due to sheer luck, cautioned Stephen Craffen, a partner with Stonegate Wealth Management in Fair Lawn, NJ.
Some financial advisors believe that active management can beat indexing in fringe markets, where a small amount of trading and a shortage of analysts and investors can leave bargains undiscovered.
"I think there are areas of the market that active management may be beneficial," Reiner said, citing international bonds. Others favor active management for high-yield bonds, foreign stocks or small-company stocks.
Christopher J. Cordaro, an advisor with RegentAtlantic of Morristown, N.J., said active management can be especially valuable with bond funds.
"Active bond managers can avoid areas of the bond market that may be overheated," he said. "They can shorten maturities to reduce interest rate risk." That's the risk that older bonds with low yields will lose value if newer bonds are more generous—a widespread concern today.
"The time I want active management is when risk is elevated," Cordaro said.
For stocks and bonds that receive heavy scrutiny, like those in the S&P 500 or Dow, it is much more difficult for active managers to find bargains, because so much is so widely known about these securities.
Many experts therefore suggest that index investments make up the core of the small investor's portfolio, since the core is typically invested in widely traded, well-known securities.
Indexed products are especially good in taxable accounts because their buy-and-hold style means they don't sell many of their money making holdings. That keeps annual "capital gains distributions"—a payout to investors late in the year—at an absolute minimum. Actively managed funds, because they do lots of selling in the pursuit of the "latest, greatest" stock holdings, can have large payouts, which produce annual capital gains taxes.
ETFs Vs. Index Mutual Funds
So if indexing is for you, are ETFs better than indexed mutual funds?
In the past few years, ETFs have moved into some very narrowly defined markets focused on very small stocks, foreign stocks and foreign bonds. While advocates think bargains can be found in esoteric markets, ETFs in thinly traded markets can be subject to problems like "tracking error," when the ETF price does not accurately reflect the value of the assets it owns, said George Kiraly, an advisor with LodeStar Advisory Group in Short Hills, N.J.
"Tracking large, liquid indexes like the S&P 500 is relatively easy," he added, "and tracking error is essentially zero for those ETFs."
Therefore, if you see worrisome discrepancies between an ETF's net asset value and price, maybe you should look for a comparable index mutual fund. This data is available on fund tracker Morningstar's ETF pages.)
The biggest issue in the ETF versus traditional mutual fund battle is the broker's commission you pay with every purchase and sale. Many actively managed mutual funds carry "loads," which are upfront sales commissions, often 3 percent to 5 percent of the investment. With a 5 percent load, the fund would need a significant gain before the investor could sell for enough to break even.
ETFs, however, can also rack up fees when used with certain investing strategies. If you are employing a dollar-cost averaging strategy to mitigate the risk of investing during a big swing in the market—investing, say, $200 a month—those commissions would add up, even if they were only $8 or $10 each at a deep-discount online brokerage. You'd also pay commissions when you made withdrawals in retirement, though you could minimize that by taking out more money on fewer occasions.
"Because of transaction costs, ETFs don't work well for a dollar-cost averaging plan," Kiraly said.
ETF fees do tend to be lower. And although index mutual funds have small annual distributions and low taxes, comparable ETFs sometimes have even smaller distributions.
So, for investing a large sum in one block, an ETF may be the cheaper choice. For piecemeal investing every month, the index mutual fund could be the better option.
A Quick Primer on ETF Tax Efficiency
John Spence for ETF Trends writes: Tax efficiency is one of the key benefits of exchange traded funds, but most investors would probably be hard-pressed to explain the details of how stock ETFs pull off this advantage.
The answer has to do with how ETFs are traded between investors. Their tax efficiency is also related to how ETFs create and redeem shares, and how they differ from traditional mutual funds.
When investors buy an equity mutual fund, the portfolio manager puts the cash to work by buying company shares. Conversely, when the fund receives redemption requests from shareholders, the manager sells stock to raise the cash, which can trigger a capital gain distribution for all the shareholders remaining in the fund.
ETFs do things differently. Invesco PowerShares has a great overview of how ETFs achieve their tax efficiency.
Investors trade ETFs on an exchange in the secondary market like individual stocks.
“When one investor sells ETF shares and another investors buys them on the exchange, the underlying securities of the ETF don’t need to be sold in order to raise cash for the redemption,” Invesco PowerShares notes.
Furthermore, trading firms known as authorized participants or APs are responsible for working with the ETF manager to create and redeem large blocks of shares, called creation units. These exchanges are “in-kind” transactions that involve stock rather than cash.
These large creation units are created and redeemed based on demand for the ETF, and selling pressure.
“An in-kind redemption process enables the fund manager to purge the lowest cost-basis stocks through stock transfers during the creation and redemption process,” according to Invesco PowerShares. “The result may be greater tax efficiency because shareholder activity and resulting portfolio turnover don’t affect the portfolio to the same extent as with mutual funds.”
Fact or Fiction: Exchange-Traded Funds Are More Tax-Efficient Than Mutual Funds
Michael Rawson, CFA for Morningstar writes: With so much uncertainty in the financial markets, there are few outcomes over which investors have much control. One area where informed decision-making can consistently pay off is tax planning. Investors in high tax brackets or with a lot of money to invest should consider which asset classes and strategies are best held in a taxable account and which are best held in a tax-deferred account. Passive strategies generally are more tax-efficient, but this is not always the case, particularly if an index fund invests in an asset class with high tax costs or tracks an index with high turnover.
Asset-Class Tax Treatment Trumps All Else
Certain asset classes offer better aftertax returns in tax-deferred accounts, such as assets that throw off a large share of their total returns in the form of interest income, which is taxed at ordinary income tax rates. For example, if an investor in the highest tax bracket were to hold iShares Core Total U.S. Bond Market ETF (AGG) in a tax-deferred account, he or she would have earned a 5.78% annualized return for the five years ended Dec. 31. That same investment held in a taxable account would have returned only 4.43% for an investor in the highest tax bracket. When choosing a fund for a taxable account, one would have been better off with the iShares S&P National AMT-Free Muni Bond ETF (MUB), which returned 5.48%. But in the tax-deferred account, the muni fund underperformed the taxable iShares Core Total U.S. Bond Market fund.
Investments that generate nonqualified dividends, such as REITs, are also better held in tax-sheltered accounts because those dividends are taxed at investors' ordinary income tax rates. For example, T. Rowe Price Real Estate's (TRREX) 10-year annualized return of 12.53% drops to 10.99% for an investor in the highest tax bracket once taxes are factored in.
Qualified dividend income, on the other hand, is somewhat tax-advantaged compared with ordinary income. For 2013, the highest ordinary income tax rate is 43.4% when including the 3.8% Medicare tax surcharge on high earners, while the highest tax rate is 23.8% on qualified dividends. Over the long term, dividend-paying stocks have performed well, so risk-tolerant investors with additional money to invest can hold dividend-focused funds in taxable accounts, despite the slight tax disadvantage compared with holding them in a tax-deferred account. Naturally, you would put dividend-paying funds in a tax-deferred account first, but those with large taxable accounts should not necessarily avoid dividend-paying stocks. It is important to remember that it is the total aftertax return that is most important, not necessarily minimizing taxes. For example, while it is true that during the past five years an investor in Vanguard Dividend Growth (VDIGX) paid more in taxes than an investor in a typical S&P 500 Index fund, VDIGX still had a much higher aftertax return.
Strategies Still Play a Role
Although the asset location decision--which asset classes to hold in which account types--is a crucial component of tax management, investors also can help improve their aftertax results by focusing on tax-efficient strategies for their taxable holdings. Exchange-traded funds are often touted as tax-efficient investments because they can gain an edge through the use of an additional tax-fighting weapon at their disposal: the creation and redemption process. Rather than selling stock to meet investor redemptions, ETFs are redeemed through an in-kind transfer with an authorized participant. The in-kind, or shares-for-shares, transfer allows for the elimination of low-cost-basis shares, thus reducing (but not eliminating) the possibility of future capital gains distributions.
But here is the rub: This in-kind creation and redemption mechanism works best for U.S.-stock funds. Once we venture outside of the U.S.-stock asset class, the tax benefits stemming from the in-kind creation and redemption process might diminish somewhat. For example, in the bond market, in-kind creations are more difficult, so cash creations and redemptions are common. During the past five years, both iShares Core Total U.S. Bond Market and iShares iBoxx $ High Yield Corporate Bond (HYG) were no more tax-efficient than comparable index mutual funds.
Investors also should remember all the commonalities between the taxation of ETFs and mutual funds. ETF investors will owe taxes on the distributions of dividends or interest income that an ETF receives and passes through to investors. They also will face capital gains taxes when selling the fund, regardless of whether the fund is an ETF or index mutual fund.
And even for U.S.-equity ETFs, most of their tax efficiency stems from the fact that they are index funds, which typically have low turnover and thus generate fewer capital gains than actively managed funds. There are plenty of ETFs (and conventional index funds, for that matter) that follow higher-turnover, so-called strategy indexes, which might be less tax-efficient than traditional, market-cap-weighted index mutual funds. For example, PowerShares Fundamental Pure Large Core (PXLC) had a five-year tax-cost ratio of 0.63, high by equity ETF standards, likely because the fund has high turnover.
In addition, a handful of tax-managed mutual funds--traditional open-end funds that hew closely to market benchmarks but have active oversight--have achieved tax efficiency by following best practices, such as limiting trading, keeping track of tax lots, and appropriately timing the sale of high-cost-basis shares. In summary, tax efficiency comes from diligent implementation of a sound low-turnover strategy, not necessarily from some magical tax loophole afforded only to ETFs.
Delving Into the Details
Let's look at some specific examples to illustrate the point that ETFs can be more tax-efficient than active mutual funds but are not necessarily more tax-efficient than well-run index mutual funds.
The iShares Core S&P 500 ETF (IVV) had a 10-year pretax annualized return of 7.03% and a post-tax (but preliquidation) return of 6.71%. This results in a tax-cost ratio of 0.30. The tax-cost ratio measures the amount of return lost to taxes, so a lower number in combination with a higher after return is better. A similar ETF, SPDR S&P 500 (SPY) had a 6.99% pretax return and 6.65% post-tax return, for a tax-cost ratio of 0.32. The average tax-cost ratio for actively managed large-blend funds during the past decade has been 0.60, so these two ETFs have been much more tax-efficient.
But a number of index mutual funds and tax-managed funds have also been tax-efficient. The institutional share class of Vanguard Institutional Index (VINIX) had a pretax return of 7.11% and 6.78% post-tax, for a tax-cost ratio of 0.31. This Vanguard index mutual fund was as equally tax-efficient as the two ETFs.
In theory, an equity ETF could be even more tax-efficient than an index mutual fund, but it is hard to find the data to prove it. One reason for that is ETFs have eliminated a large chunk of their index-fund competitors. Back in the year 2000, there were more than 118 index funds in the large-blend category; today, there are 84, despite the fact that indexing has continued to grow in popularity. With the exception of Vanguard's index-fund lineup, all of the interim net new inflows into the category have gone to ETFs, while many index mutual funds have languished. Competition from ETFs has washed out more costly and less efficient competitors in the realm of traditional index funds. The end result is a leaner, less expensive, and more efficient menu for investors to choose from.
Data sourced from iShares, PowerShares, T. Rowe Price, Vanguard, and Morningstar. Tax-cost ratio data reflects five- and 10-year periods ended Dec. 31, 2012.
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