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Today we will start to look at the perceived advantages of exchange traded funds (ETFs) versus open-end index mutual funds.

Depending on the investor, some of these may be more important than others.

Or possibly these potential benefits may actually not entice an investors to choose ETFs over open-end index mutual funds. I write, you decide.

Let us begin with potential trading advantages.

Active or Speculative Trading

Active traders like ETFs over open-end funds.

ETFs are traded intraday so traders can each buy and sell the same ETF multiple times in a single day if they so wish.

With an open-end fund, traders may only buy or sell fund shares after the share’s closing net-asset value (NAV) is calculated. For most funds, that is once daily, but not for all funds.

If you want to potentially day trade indices on various asset classes, ETFs are preferable.

While most readers are not day-traders, at times it is beneficial to be able to buy or sell during the trading day. For example, perhaps the market is falling significantly. You might be able to sell your ETF shares in the morning, thereby receiving a higher sales price than if you had to wait until the end of the day as with an open-end fund.

Note that I differentiate between active traders (or day traders) and investors. I have nothing against those that want to trade often. But I consider this to be speculation, not investing (in the true sense of the terms). Further, it takes substantial time and effort to be a day trader and best left to those with the expertise, investment tools, and extreme risk tolerance. Finally, the more one trades, the more transaction costs and possiblly taxes are generated. I would not recommend highly active trading for individuals seeking long-term wealth accumulation.

Improved Liquidity

Having the ability to trade ETFs continuously during exchange hours usually makes ETFs quite liquid as compared to open-end funds that typically only allow purchases and redemptions once daily, after the closing NAV has been calculated.

But for long-term investors, usually this is not a major issue. Long-term investors have lengthy time horizons and daily price fluctuations are not significant concerns. If you can trade once daily, I think that is adequate for most investors.

I would caution though that some funds may not be valued daily. Rather, they may only be valued weekly or even at longer intervals. The longer the time frame between being allowed to buy or sell shares, the greater liquidity risk becomes a factor. If the fund you are considering only allows trades once a week or once a month, I suggest you consider ETFs as an alternative.

While ETFs tend to be more liquid than open-end funds, there is a caveat. Like common shares, to be able to buy or sell ETFs requires a counterparty. When you are selling, you need a buyer. If the ETF you are considering has a limited number of shares outstanding or is not listed on a major exchange, these may indicate that the ETF has liquidity issues.

Although most popular ETFs will not normally have liquidity issues, you can assess the liquidity of an ETF (or any exchange traded investment) yourself.

Check the average trading volume over daily and weekly ranges. If you intend to purchase 10,000 shares and the ETF only trades an average of 1,000 daily, it might be difficult to sell all your shares at prevailing market prices.

Further, review the bid-ask spreads for these ETFs. Spreads for liquid investments should be very close to each other. That means that investors do not have to budge greatly from their initial positions to close the transaction. But say you want to sell 10,000 shares at the last sale price of $10 per share. You post your ask price and wait for the sale to occur. Unfortunately, no buyers want to pay $10 for your shares. In fact, the closest bid is for 5,000 shares at $6. Either the interested buyer needs to increase his bid by 67% or you need to reduce your asking price by 40% or you both need to meet somewhere in the middle to do the deal.

Counterparty risk may also be a consideration against buying an open-end mutual fund. With most ETFs there is an adequate number of shares outstanding with a wide variety of investors present to buy and sell. However, with an open-end mutual fund you are buying and redeeming shares directly with the fund company. Should the fund company become insolvent, investors in funds of that company may have difficulties redeeming their shares.

So, before investing in an open-end mutual fund, I suggest you ensure that the fund company is in strong financial shape.

Trading Flexibility

ETFs offer greater trading flexibility than open-end mutual funds.

We already discussed above the increased possible frequency of ETF trades. But there are other potential advantages in trading ETFs.

As you trade an ETF exactly like a stock, you can enter a variety of trading orders. Besides buying or selling at the current market price, investors may engage in other tactics, including limit or stop-loss orders.

Open-end mutual funds are only purchased or sold at the fund’s per share closing NAV. You cannot put in orders at different values.

You can also short ETFs in many jurisdictions. That is, you “borrow” shares of the ETF and sell them in anticipation that they will fall in value. If the ETF price does decrease, you buy the shares back on the open market, give back the “borrowed” shares to the lender, and pocket the profit on the difference. Of course, if the price does not fall, then you will face margin calls and possibly steep losses when you close the short position.

You cannot short open-end mutual funds as you are buying and selling them directly from the fund company.

I think that being able to enter non-market orders is advantageous, especially when rebalancing one’s portfolio. That said, if you are investing for a lengthy period chances are that buying or selling based on NAV will not have an impact on your returns.

As for shorting, or even using margin accounts in general, I do not think they are necessary in order to create a strong portfolio.

Next, a few more areas where ETFs are considered preferable over open-end mutual funds.

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