In this final instalment of our series of posts (see the earlier posts here – Part I- Introduction to ETFs, Mutual Funds, REITs, ETNs , Part II- All you need to know about REITs, ETNs), we will assume you have decided to invest in a fund rather than directly in the market. However, there are still some choices to make regarding which type of fund best suits your needs, as well as finding the right fund within your chosen category. This article will focus on ETFs and Mutual Funds (MFs).

Note on REITs: For direct investment in real estate, the best fund is the REIT. The other investment vehicles may invest in the real estate market in various ways (through construction companies, lumber prices, etc.), but for investing directly into properties, the REIT is the best option. For REITs, the investor will need to understand real estate. The biggest advantage of REITs is that the investment is usually much more liquid than the underlying.

Should you invest in ETF or MF?

Both offer diversification. Both have low-fee variants. Both can be actively or passively managed. Both offer exposure to less-accessible asset classes. So which one should we choose?

The answer lies in your needs. In our first article of the series, we demonstrated the differences between ETF and MF structures. These differences do become important, especially regarding investment style, fees, and taxes.

The timing of Pricing, Orders, and Holdings Values

For those that are interested in trading short-term (i.e., intraday), there’s no competition. Since MFs are only valued at the end of the day, there is no day trading to speak of, and orders are only completed after the end of the trading day. ETFs update their prices continuously simply because they are traded openly. The IIV also updates regularly throughout the day, so day traders who want to know the underlying position’s value at all times will be able to easily get that information. Even for swing traders that have week-long or month-long time horizons, MFs are only required to publish their holdings quarterly and do so, whereas ETFs will publish their holdings daily. In fact, actively managed ETFs are required to publish holdings daily. Therefore, if current and frequently updated holdings are important to you, ETFs offer an information advantage.

For longer-term investors, the difference is less stark. Aside from leveraged and inverse ETFs, whose leveraged goals do not extend across time, ETFs and MFs are more similar. This is where trading fees and taxes come into the picture.

Trading Fees

Trading fees are levied every time shares of an ETF are bought or sold. For long-term holders, this may seem insignificant. However, consider an investor who automatically invests a portion of a paycheck into a fund. No-load MFs might be more investor-friendly. MFs that charge sales loads, of course, will not, but there are no-load MFs whose slightly higher management fees might be offset by frequent no-load share purchases for long-term investors. If you plan to frequently increase your position in a fund, it is wise to consider a no-load MF over an ETF with a broker charging transaction costs.

Fund Fees

When deciding on an ETF or MF, ETFs usually have lower fees. Passive ETFs are also lower in the fee-charging hierarchy than active ETFs. But be aware that some MFs, especially the index-based passive ones, may also boast very low fees since they have less transaction and analysis costs to cover.

And this is where structure becomes important again: since passive ETFs rarely buy and sell their portfolios, they incur fewer transaction fees. The semi-close-ended structure of ETFs means that they do not need to redeem shares as often as MFs. To satisfy cash outflows of redemptions, funds need to sell off assets to acquire liquid funds. MFs must do this constantly as investors enter and exit the fund, but every time a retail ETF investor decides to sell, there is no transaction cost incurred for the fund, only for the investor (at the broker).

Of course, when authorized participants redeem shares, ETFs must also sell assets (or trade), but if there is little arbitrage opportunity, there is no reason for authorized participants to demand redemptions. Thus for passive index ETFs that use physical replication (buy the underlying directly), there are often few transaction costs passed on to the fund holders.

Tax Considerations on Distributions

Due to the purchase and sale of assets, hard capital gains and losses are realized for MFs more often than ETFs. These capital gains may be distributed to the fund holders in the form of dividends, but their amounts accrue throughout. Since investors cannot control when a fund realizes the gain, MFs might cause more uncontrolled tax events than an ETF. This is especially true for highly-traded (i.e., oft-redeemed) and actively-managed MFs.

Perhaps more interestingly, MFs are buying and selling shares constantly to meet redemption and creation requests. For ETFs, however, authorized participant transactions are often made in kind, meaning shares of the ETF are traded for shares of the underlying securities. No purchases or sales are made, so no taxable events occur. This is how ETFs achieve near-zero capital gains distributions, and therefore near-zero capital gains taxes for ETF investors.

Target Asset Class

Another important consideration is the target asset class. For index funds, we have no difference on this consideration. It becomes relevant when an investor is seeking a niche. ETFs tend to be more likely to invest in niches, especially because lower liquidity is not as problematic for creation/redemption as it is for MFs. MFs need liquid assets to produce cash flows for redemption and entry points for creation, but large investments by MFs could move markets on small or illiquid stocks. Thinly-traded asset classes are not served by MFs for that very reason, but thinly-traded asset classes can be interesting investment targets. In that case, ETFs are a clear choice.

Convenience and Contributions

Many retirement plans use MFs. That makes MFs more convenient for investing than ETFs for those interested in investing paychecks directly into funds. Investing in ETFs might require the employee to take cash, deposit it into a brokerage account, and then purchase the security. On a biweekly or monthly schedule, this can quickly become an annoying task.

Even more importantly, if an employer participates in contribution matching for a retirement plan, taking cash for self-invested ETFs leaves money “on the table”. An employer matching 5% on retirement plan investments on a £3000 monthly paycheck is effectively £150 for free, every month. Just 10 years at a company, which is certainly not long enough for retirement, is £18,000 extra simply for using the company’s retirement setup. If the setup only offers MFs, then the higher MF fees might be worth the increased income, even if that income is only accessible at retirement time.

So, once you’ve decided which fund or a blend of funds to invest in, you need to understand how to choose a fund. Let’s start with the pricing mechanisms.

Fund Pricing and Differentials

For ETFs and MFs, pricing is related to the underlying portfolio. In the case of highly liquid and temporally-synchronized markets, there is not much of interest for pricing. However, sometimes ETF share prices can deviate from NAV and even the IIV.

For MFs, pricing is very straightforward: you get your share of the assets, which is directly derived from the NAV. Also, since there is no secondary market, MFs don’t have price differences between their share prices and NAV. Thus pricing a MF is trivial: you get what your MF’s management states as the price.

For ETFs, the story is a bit more interesting. The biggest price deviations tend to occur for trading hours differences. If an ETF holds assets outside the investor’s home market, specifically in another time zone, then the ETF’s portfolio trading times will be temporally mismatched with the ETFs share trading times. That creates price gaps due to information and timing risks, especially in volatile markets. Of course, for foreign-investing MFs, the same problem occurs, but there is only one price available to the investor, and that’s from the NAV published by the MF.

Another interesting cause of NAV-price differences arises in bond ETFs. Since ETFs are actively traded, the market must price in the bid-ask spread for bonds that are also actively traded. Sometimes that means there is a premium for the fund because market forces skew in the ask direction, while the ETF is publishing a NAV or IIV derived only from the bond’s bid price. Again, this happens to bond MFs as well, but the MF’s management calculates the NAV, not the market, so market forces and investors have no direct impact on pricing.

Evaluating an ETF – points to consider

Finally, let’s talk about how to evaluate an ETF’s performance. How well is it doing compared to its peers? Is your ETF liquid enough? What are some of the overlooked risks of your particular choice of ETF? These are all important considerations when choosing an ETF.

Metrics

We like to use numbers in finance. So, what are some of the metrics used for evaluating an ETF? Expense ratio, tracking error, and liquidity are the top three.  Assets Under Management (AUM) is also important.

Expense Ratio

This is basically a management fee, and it includes things like transaction costs and personnel salaries. Obviously, fees are not expensed directly to fund holders due to the secondary market dynamic, so the fees are deducted from the NAV. These are done as evenly as possible, even though day-to-day expenses may shift.

According to the Investment Company Institute (an industry organization), ETF fees on index and bond ETFs have declined since the start of the millennium. The asset-weighted average of index ETFs (i.e. the bigger the fund, the more weight it carries) was 0.23% in 2016, and it is converging with the bond ETF fee of 0.20%. That is a very low fee. Coupled with the tax benefits of low-turnover index ETFs, they do indeed seem like great investments.

Note, however, that ETF expense ratios are not all so attractively low. Actively managed funds will be much higher since they have higher transaction costs and may perform expensive analyses of the market. More niche-focused ETFs will also carry higher fees due to the analysis needed or the uncertainty associated with their underlyings. Another crucial point is that the expense ratios do not include the broker commission fees, so transaction costs for the investor must be calculated separately.

Tracking Error and Difference

These are two closely intertwined but different terms. Indeed, tracking error is a derivative of tracking difference. Tracking difference is the gap between the fund’s return and the benchmark’s return. This is calculated as the fund’s total return against the benchmark’s total return over the time period. Negative differences mean it underperformed. Since expenses must be taken into account to determine returns, it follows that most index funds have negative tracking differences, because they closely track the index but must deduct the expenses from their total returns.

Tracking error, on the other hand, is the consistency with which the tracking difference follows the index. It is calculated as the standard deviation (adjusted to the time period, which usually means annualized) of the tracking difference. A tracking error of zero means the tracking difference remained exactly the same throughout the period. If a fund’s expenses are 0.25% and the tracking difference is -0.25% for the whole period, then the tracking error is exactly zero. This is why ETNs have zero tracking error: they are synthetic instruments and therefore do not actually need to hold the portfolio, they just update their numbers.

There are several key parts that play into tracking difference. Most are concerned with expenses, but others include things like rebalancing timing, dividend payment timing, and sampling. The last concept, sampling, is used when an ETF holds a representative sample of the underlying portfolio. The reason for this is because some indices are very broad, including illiquid or inaccessible securities. Instead of buying and constantly rebalancing thousands of securities, the fund simply buys a close replication of it, possibly ignoring low-weight components. This is quite common with bond funds, which may have thousands of variations of maturities, interest rates, issuers, and yields for a single index.

When dealing with actively managed, synthetic replication, or leveraged funds, tracking difference and error are even more important. For passive index funds, tracking error and difference will likely be low. But other funds are much more reliant on management decisions, and therefore, their tracking metrics provide insights into the capabilities of management.

If an actively managed fund has a history of high tracking error, then the investor immediately knows performance is not consistent. If the tracking difference is negative for funds that try to beat the markets, then there’s no reason to risk capital for a trading strategy that clearly isn’t performing. If tracking error in a synthetic fund is high, there might be problems with management’s choice of derivatives in its portfolio.

Liquidity

The last really important consideration when choosing a fund is liquidity. A fund with low liquidity is difficult to trade, and as such, the share price may diverge significantly from the NAV. Spreads might also widen, so even if the average price is near the NAV, an investor’s price might be considerably off. When checking the liquidity metric, investors should make sure the spread is not too wide during trading hours and that sufficient amounts are traded daily in comparison to the expected investment. If your investment will make up 5% of the average pounds traded per day, it is an ETF to stay away from.

AUM

AUM is not quite as important as the ones above. However, AUM does correlate with some important aspects. First, low-AUM ETFs tend to have less investor interest, and therefore lower liquidity. Furthermore, low-AUM funds may not be able to transact in niche markets or their transaction costs for such markets might be high. Finally, low-AUM funds might have higher expense ratios, because the same dollar amount in expenses is spread out over fewer investors and less capital. Of course, this does not mean low-AUM funds should be entirely disqualified. If a new fund is creating a new niche, then it might be worth it to be an early investor.

Returns

Returns could fit under metrics, but we are splitting it into its own category here because returns are the reason one invests. The most important return to consider is total return, which is the amount returned over a period, including dividend and capital gain distributions as well as share price changes. For actively managed funds, if the returns are not significantly and consistently higher than the market, it is probably better to invest in a passive fund.

It is also important to compare the returns across ETFs. Some are better than others at tracking, managing expenses, or picking winners. However, it is important to remember that consistently beating the market is a historical difficulty (or a Ponzi scheme).

Overlooked MFs & ETF Risks

In this section, we wanted to point out some risks that are often overlooked when investing in ETFs. The usual, like tracking error and illiquidity are almost always considered because they are prominently discussed. Others are less prominent.

Currency Risk

For any fund that holds any overseas components, currency risk is always a problem. Sure, most currencies are relatively stable, but if a fund invests in a politically volatile area, then currency risk may come calling, and its calling could be quite harsh. Conversely, currency funds are particularly designed for currency risk in mind, so a hedging strategy could be employed.

Interest Rate Risk

More so for bond funds than equities or commodities, interest rates must be paid attention. For income-style funds that are meant for dividend or coupon distributions, it is not quite as important. But if you are investing for returns on bond prices, then interest rate risks is a real risk that must be considered.

Counterparty and Credit Risk

For synthetic funds, these two risks become apparent. Since the underlying portfolio may not be assets but derivatives with only cash flows, the failure of the derivative’s counterparty might impact your fund. Also, credit risk becomes important if the ETF is holding debt securities: if the issuer stops paying, then the fund will stop receiving its income. That means you will stop receiving your return.

Summary

We hope this series has helped you better understand various kinds of funds. There is a lot more information out there, but if you understand the information set out in this series, you have a strong foundation for fund investing. Of course, it is impossible to assess every fund, so you will need to do your own research and find which funds are the most suitable to your investment strategy and risk appetite. For now, happy investing.