Forward Guidance: Nicholas Vardy Explains Exchange-Traded Funds
Samuel Taube: Joining us today by phone is The Oxford Club’s new ETF Strategist, Nicholas Vardy, and he’s are answering some common questions about ETFs. Nick, thanks for joining us.
Nicholas Vardy: Thanks for having me, Sam.
ST: So let’s start really simple here. For listeners who may not be in the know, what are ETFs and how do they differ from mutual funds?
NV: Well, that’s a very broad question. Let me start off with telling you what ETFs are. Exchange-traded funds, or ETFs, are pools of investments organized around a certain asset class, a specific investment strategy or a particular investment theme.
All ETFs are essentially index funds in that they track an underlying specialized index, and what distinguishes them in particular from mutual funds is that you can buy and sell them like a stock at the click of a mouse.
Now, ETFs have exploded in popularity over the past few years. Since 2000, the peak of the dot-com boom, ETF assets have grown at an average annual rate of a pretty remarkable 142%. The same number for mutual funds is about only 8%. There’s been a huge divergence in the development of ETFs versus mutual funds.
Today, there are more than 2,100 ETFs in the U.S. More than $4 trillion is managed in ETFs globally. In 2017, ETFs attracted more than $600 million. What’s interesting about that figure is that it is actually approximately twice as much as the peak value bitcoin reached in 2017.
NV: So it’s actually a very popular asset class or a very popular way of investing.
It’s not a new one; ETFs have been around for a while. In fact, just in the past month, one of the biggest ETFs, the SPDR S&P 500 ETF (NYSE: SPY), celebrated its 25th anniversary.
This has become a huge investment vehicle in the U.S. It’s the single most- traded ETF on U.S. stock markets. It’s got an average trading volume of 73 million shares, and it has a market cap of $285 billion.
Now, if it were a company, it would be one of the top 15 largest companies in the U.S. by market cap. So ETFs have been around and they have gotten quite big.
ST: Interesting. I see. Now what are some advantages offered by ETF investing over investing in individual securities? And as a follow-up, what are some advantages that they offer over mutual funds?
NV: Sure. Well exchange-traded funds actually offer the best of both worlds with respect to stocks and mutual funds. On the one hand, as I mentioned, ETFs trade like stocks on stock exchanges. On the other hand, they’re investment funds in the fact that they track an underlying index that’s linked to a diversified portfolio.
So specifically, an ETF’s advantage over stocks is that it’s less risky because it invests in this diversified portfolio.
If you think about it, when you invest in a single stock, you’re taking on – what in finance is called – specific risk or company risk. With ETFs, that single stock risk dissipates across a large number of holdings as it would in any large portfolio. So with ETFs, you get the benefit on diversification.
ST: I see.
NV: Now with respect to mutual funds, they’ve got a whole heck of a lot of advantages. Some of these are technical. Some of these are less technical. Let me just go over some of the technical ones very quickly. There are about six that I’ve broken up the advantages of.
So the first advantage is that mutual funds often have investment minimums and early-redemption fees. With ETFs, there’s no such thing. There’s no minimum investment of $2,500 or $10,000. It’s much easier access.
Advantage number two is you have real-time tracking of the value of the ETFs. Now, mutual funds, if you recall, only give one price at the end of the day. Meanwhile, ETFs price all day long and you can find the live price for an ETF at any time on any brokerage account.
NV: So as a result of that, we segue into advantage three. ETFs offer real-time trading. Now, mutual funds, since they’re only priced once a day after the close of the market, can only be bought and sold at the end of the day. ETFs can be bought and sold whenever the markets are open. So that’s a big advantage.
NV: Advantage number four, and this is a crucial one, is cost. And this is the really big, huge edge that ETFs have developed and the reason they’re growing at such a remarkable rate. For the most part, ETFs are cheaper than the average mutual fund.
If you look just at the average ETF, it carries an expense ratio of about 0.44%. There are some that are much cheaper. There are some that are more expensive, but the average is that level 0.44%. That means investing in this ETF or an average ETF will cost you $4.40 in annual fees for every $1,000 that you invest each year.
By way of comparison, the average mutual fund has a management fee of 1.13%. Now, even though that average management fee has been dropping like crazy in the past five or six years as the competition for ETFs has heated up, today, based on the averages, mutual funds are a whopping 157% more expensive than exchange-traded funds.
ST: If you don’t mind me interrupting, is there a particular reason for the discrepancy in costs? Is that because mutual funds require significantly more management or anything like that?
NV: I think it’s legacy cost. You know, there is actually an S&P 500-tracking mutual fund out there that charges more than 2% a year for simple index-tracking mechanisms.
ST: Oh wow, that’s crazy.
NV: And it gets away with that because it’s got plenty of legacy assets. People have had their money in there for so long, and they’re not pulling it out.
And so if you go back a few years, you know, a decade or two, you also had mutual funds that had these huge front-end loads. So when I was managing money about 20 years ago in London, we had U.S. retail products where when you bought into the mutual fund you would actually have to pay a 4.75% front-end load when you got into the mutual fund.
So on day one, for every $100 that you invested, you actually only invested $95.25 because you were paying that sales commission.
Contrast that with ETFs today where there are no front loads and you only pay the cost of a stock commission, which is now down to $5 to $7 in most major online brokerages. In fact, some brokers like Fidelity, Schwab and Stock Trade even offer commission-free ETFs if you buy their own kind of branded products. So the cost edge that an ETF has is really, really remarkable.
So going on to advantage number five, ETFs are more transparent. Mutual funds are only required to disclose their holdings once per quarter. With an ETF, you always know what you own on any given day. They have to disclose their holdings on a daily basis – so massively more transparency – so that should give investors a higher degree of comfort.
Advantage number six is a little bit technical, but it’s extremely important – and that’s the tax treatment of ETFs versus mutual funds. Because of the way ETF units are created and redeemed, the baskets of underlying securities are exchanged in kind. Therefore, this does not trigger a taxable event.
So the bottom line from an investor’s standpoint is that if you invest in an ETF, you are much less likely to get a bill from your ETF provider for capital gains at the end of the year compared with if you invested in the exact same strategy in a mutual fund.
And because ETFs are passive, they also tend to have less turnover than their mutual fund cousins. So those are six huge advantages – technical advantages – that ETFs have over mutual funds.
ST: I see. That’s very descriptive. But you’ve also written about some other nontechnical advantages that ETFs offer. Could you elaborate a little bit on those?
NV: Yeah, and this is really what’s most exciting about the whole ETF investing paradigm in that ETF-investment universe. The huge advantage they have over individual stocks and mutual funds is their flexibility.
As I’ve written previously in my IU columns, you think of ETFs as Lego building blocks that allow you to build, brick by brick, a portfolio to fit your own specific investment objectives.
Now, why can you do that? You can do that because the universe of ETFs expands the range of investment possibilities far beyond a traditional U.S. stock and bond portfolio.
With ETFs today, among those 2,100 ETFs that are accessible for U.S. investors, you can invest in almost any asset class, whether that’s stocks, bonds, commodities or currencies. You can invest in some of these on a leverage basis.
In fact, you can invest in global markets. The range of investment opportunities with exchange-traded funds really seems almost infinite. And what’s great about it is that there’s an incredible level of creativity in the ETF sector, which is quite remarkable.
And so any time there is a new investment theme, a new investment development, a new investment meme that comes about, you can be sure that there’s going to be an ETF provider that is going to catch on to that and design an ETF.
And one interesting example I read just today… And again, this is a very, very dynamic space… Just today, January 17th, there are two blockchain-related ETFs that are being launched today. Now, blockchain, as you may know, is the technology behind cryptocurrencies.
NV: So what’s interesting is that the SEC had all sorts of concerns about launching actual cryptocurrency ETFs, and those are right now gummed up in the regulatory works. But there are another couple of ETF providers that came up with a blockchain-related concept for exchange-traded funds, and they were able to get that through the SEC.
And it also shows you how creatively ETF providers think and how they can adapt to any future change in the range of any possible investments that emerge at any particular historical moment.
ST: Right. So are there any downsides to investing in ETFs when compared to stock picking or investing in mutual funds?
NV: You know, there are some small downsides. I think a lot of it depends on the kind of guidance you have and how much expertise you have in a sector.
John Bogle, who’s the very famous curmudgeonly old guy and the founder of Vanguard, who founded the investment funds back in the early 1970s, has a real beef with ETFs, which is ironic because Vanguard is now the second or third biggest largest ETF provider in the world.
NV: But his beef with the concept of ETF is really one of the very first advantages that I mentioned. It’s the trading flexibility of ETFs, the fact that you can buy and sell them at the click of a mouse because in his view, the trading flexibility is a double-edged sword.
The ability to trade ETFs any time and as much as you want is a benefit for active traders, but that flexibility can entice some people to trade too much. Bogle’s argument is that the high turnover in a portfolio, which is encouraged by the flexibility of ETFs, increases its costs and reduces returns.
NV: And you know that’s really a question of how you approach the market. I think if you have good guidance in the ETF market, then that is not a disadvantage. I actually think that’s an advantage, but this is how he likes to frame it.
A couple of technical points… Every time you buy and sell an ETF, you pay commission – the 4, 5, 6, 7 dollar commission that you pay with an online broker. With no-load mutual funds, you don’t have to pay a commission.
So if you have a savings plan where you are putting away $100 a month and putting it into, let’s say, a U.S.-index-linked mutual fund, then the ETF version probably doesn’t work out for you because even with the $5 brokerage commission, you’re going to put only $95 to work.
So ETFs aren’t made for dollar-cost averaging for a small amount of money – so that’s something that should be a caveat.
Other issues are if an ETF is thinly traded, there can be problems getting in and out of the position depending on how much volume there is. ETFs also have a bid-ask spread, so there’s a little bit of loss that you can endure there, just like in a stock.
And some specialist strategies, and there are a heck of a lot of specialist strategies, you know, some of them viable, some of them not. They sometimes suffer from tracking error, that is the inability to track the underlying index, which they seek to replicate.
But again, the biggest sensible weakness is the flexibility, and I actually think that’s their biggest strength.
ST: Right. But it certainly makes sense that for certain investors, overactivity can be a handicap for them in ETFs.
Now, it seems like ETFs, as you have said, come in a variety of different flavors. There are sector ETFs, regional ETFs, ETFs that cater to specific approaches like growth investing and value investing. Do you have a favorite type, or a type that you think is particularly useful to investors?
NV: You know, I do have my favorite, and I have a very clear rule for that. My favorite type of ETF is the one that makes money for investors.
ST: That’s a good type.
NV: Yeah, that’s the good type. And let me tell you how that links to my personal investment philosophy, which I think is very closely aligned with a wide range of investment opportunities offered by exchange-traded funds.
To put it simply, there are always markets that are going up and there are always markets that are going down. As a matter of investments, I am agnostic as to how and in which asset class I make money.
Today, that might be the Vietnamese ETF that offers the best opportunity – I’m just giving that as an example. Tomorrow it might be a commodity ETF linked to the price of palladium. In two years’ time, the best ETF opportunity could be one that goes short of the S&P 500 because we may be in a bear market then.
Sometimes value investing is in favor. Sometimes dividend-related ETFs are in favor and they offer you the best opportunities. The point is that the market environment continues to evolve. It continues to change. Change is the only constant.
And so my approach is I’m not going to say that I’m just a value investor and that’s the only thing I do and then suffer for months and years at a time. I want to be very flexible in my investment strategies, and ETFs offer me the opportunity to do that.
Now, the challenge of ETF investing is keeping track of all these remarkable wirings of opportunities in this ever growing space. But again, the flexibility and creativity in the ETF space means that ETFs won’t be going anywhere, OK?
So whatever the investment theme, whatever the investment philosophy, whatever asset class you can think of, there’s probably an ETF for it or there’s someone working on an ETF for it.
ST: Well cool. Nick, thanks for joining us.
NV: Thanks for having me, Sam.
*The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of Wall Street analysts.