I’ve recently started investing. I’ve read a few books on basic investment strategy (buy index funds!) and I’ve been spending some time over at the Motley Fool to get a grasp on some of the lingo. I opened up an internet brokerage account with a personal account and an IRA.
After all this reading, I cannot for the life of me figure out the benefits of a mutual fund over an ETF. But clearly, there must be one that I don’t understand. Now, keep in mind that in both cases, I’m talking about a passively managed no-load index tracking funds and ETFs. Both the standard mutual funds and the ETFs have low overhead (<1%). Both seem to get the same index return. But the ETFs seem to have several things going for them that the other funds don’t: You can buy and sell them any time like any other stock, and the comissions (at least at my brokerage) are lower for ETFs ($7) than for Mutual funds ($17). I use Scottrade, but like many other internet brokerages had similar differences in fees. Of course, I could buy direct from Vanguard for less (I think?), but I’d need $3-10K to start, depending on the fund, and I don’t particularly relish the idea of having a different account for each fund I might want to buy. In addition, the Fool mentioned that ETFs were slightly better from a tax perspective, because the funds themselves <insert something about tax minutiae I didn’t understand>.
I can see why the first might be a downside… if you don’t have the willpower not to jump in and out of the market, and thus get eaten up by fees. And I’m sure there’s some inertia in the market. People who’ve always bought mutual funds will continue to do so, and may be wary of new entrants. But there’s got to be something else that explains why ETFs haven’t almost completely replaced traditional index funds.
One factor - with the ETF you have to take into account that it will trade at a premium or discount to the underlying asset value, and you have to consider that when investing in them. Some people may feel more comfortable with the open end mutual fund whose share price is strictly determined by the assets in it. There’s a chance that the ETF you buy could tank not just because the assets it is holding shrink, but because it becomes heavily discounted on the market. Or, you could not notice you were buying shares at a high premium.
Here’s a good site for infomation on closed end funds and index ETFs:
Is there any historic precedent for an ETF trading at a substantial discount or premium? What kind of economic pressure would cause that? Is there a good way to calculate what the current discount or premium might be?
I notice that, for example, SPY, is listed right now on google finances as having a 48.56B market cap, while the 2005 Total Equity is listed as 47.03B. But one number is current and the other isn’t. Since Dec. 30, the S&P index seems to have grown about twice as much as SPY, but then I’m not sure that the “2005” figure really means the end of 2005.
It’s less likely with index funds, but it is still an issue. The etfconnect site makes the same point here, under the section entitled “investment risks”:
etfconnect uses the terminology “closed end ETF” and “Index ETF”. Many people seem to mean the latter when they say ETF, referring to the others as just “closed end funds”. Closed end funds can have very substantial discounts or premiums - you can use the search tools on that site to order by discount or premium if you like. You can find out, for instance, that most corporate bond funds are currently trading at discounts of 8-14%.
To answer one of my own questions, I did just find the Net Asset Value to Share Price comparator in the Snapshot on Morningstar.com. Clearly Google needs to get their act together.
yabob, thanks for the continuing explanations. I suppose I can see how a closed-end fund could have a substantial discount or premium, but won’t that premium or discount eventually erode (in the case of bond funds) as the bonds they hold eventually mature? Or does the fund then go out and purchase new bonds?
I can certainly see why the value might fluctuate, but I don’t understand how the market could consistently undervalue a fund by as much as 10%.
A fund isn’t necessarily holding bonds to maturity, in fact it probably isn’t. The manager is buying and selling holdings all the time.
The premium or discount for a closed end fund is a result of market pricing, presumably reflecting what the buyers think about the strategies of the fund, and the likely future values of its assets. Or perhaps readings from the I Ching if you wish to be cynical about it. Logically, the bond funds are discounted now because of the expectation of rising interest rates pushing bond prices down. Bonds aren’t attractive in the current climate, hence a bond fund has to trade at a discount to find buyers to match with sellers.
An important mutual fund vs. ETF consideration is how frequently you’ll make investments. If you plan to invest a lump sum and hold it (making additional contributions infrequently), the commissions on ETFs should be quite low. However, if you make regular investments (especially if you plan to make systematic investments or dollar cost averaging), you could be eaten up with commissions on an ETF and would be better off investing in a mutual fund.
You shouldn’t have to pay commission on the purchase of mutual fund shares. If you don’t want to invest directly with the mutual fund company (though I’m not sure why you wouldn’t), many brokerage have some sort of mutual fund supermarket that allows you to invest in the major fund without paying a commission.