In recent years the number of ETFs in the market has increased considerably.  People are investing in them, but do they really understand what it is that they are buyiing into?  As I sit down with prospects, I find that the answer to that question is mostly "No".

What is an ETF? An ETF is basically an open-ended mutual fund, in the sense that it is a basket of securities purchased by the ETF sponsoring financial institution.  The basket is divided into ETF units, and each unit is representative of the basket, in the same manner that mutual fund units are representative of the investment positions of the mutual fund.

Image: stockvault.net

From an investors point of view, the biggest difference between an ETF and a mutual fund is in the way the units are bought and sold.

Mutual fund units are not listed securities and therefore, the price of a mutual fund unit is not quoted on the stock exchanges.  If you want to buy or sell your mutual fund units you must deal directly with the mutual fund company.  If you are selling the mutual fund company must buy from you, and if you are purchasing the mutual fund company will sell to you.

Mutual fund companies calculate the value of the outstanding mutual fund units based on the closing market price of the securities that they hold – this is called the Net Asset Value or NAV.  All transactions, whether buy or sell are priced at the last calculated NAV.  Some mutual funds calculate the NAV on a daily basis, but not all of them do so, especially real estate mutual fund trusts do not usually calculate the NAV on a daily basis.

Let’s say your mutual fund owns three different stocks, here is a simplistic illustration of how the NAV would be calculated:

                        Total units issued        Closing Stock Price yesterday            CSP today

        Stock A           1000                            $10                                                      $12
        Stock B           1000                            $12                                                      $15
        Stock C           1000                            $15                                                      $20
        NAV per unit                                      $12.33                                                 $15.66

When investors are dealing in mutual funds, they cannot time their transactions exactly.  Most of the time mutual fund units are sold by mutual fund sales reps who work for banks, insurance companies or other financial institutions.  Lets say you need $5000 from your mutual fund account and you call your mutual fund guy and tell him what you need.  Your rep will then prepare the trade ticket and pass it on to his back office, or submit the request on the on-line trading system.  And you will receive the NAV as of close of trading on that day. If you thought that the price of Stock A was going to do something today ie., increase or decrease substantially, you think you could place a limit order? Of course not. 

Because mutual fund companies are dealing with daily in-flows and out-flows of funds they have to manage their cashflow, this adds to their management costs, because if there is a gap between money that came in for purchases and money going out as redemptions they have to come up with the difference through banking arrangements.

In addition, mutual fund companies have to maintain a settlement department that implements all the transactions (even though most of this is done through computers, the financial industry is one industry that cannot do away with paper records because of legal liability issues).  Sometimes, mutual fund companies with use an external service for their settlements and transactions.  One way or another, this translates into additional costs for them.  Guess who pays for these costs.  You got it! You do.  All of the costs of running the mutual fund including personnel costs, software costs, legal costs, trading costs, office space, equipment and coffee are deducted from the NAV (not the profits) of the mutual fund.  This sort of stuff is called the MER or management expense ratio of the mutual fund.  The higher the MER, the lower the return to the investors.

So when the market goes into a dip and on top of that your mutual fund company charges you an MER of 3%, you get badly hit, and I mean really badly.  Your investments may never recover from this sort of a hit.  But that is the cost you pay for buying the knowledge and expertise of the guys who manage your money.  Effectively speaking your investments need to make 6% at an MER of 3% so that you can clear 3%.  It’s not all bad folks. There are some really good mutual fund managers out there who consistently make money for their investors and are worth the money you pay them.

On the other hand ETFs are listed on the stock exchange just like the stocks and other securities that constitute them.  This means that you can buy and sell directly on the exchange and there is no ETF management company who intervenes in the transaction.  Thus, ETFs have very low management fees – they don’t need to employ a settlement department and they don’t need banking arrangements. Plus you get to control what price you want to buy or sell at and the timing of your order.

An added benefit of ETF investing is that you can take up more focused positions in certain sectors.  Whereas a mutual fund on average contains upward of 40 different securities, ETFs can consist of as little as eight different stocks.  So if you like Canadian banks you can easily find an ETF that invests only in the large banks whereas you will never find a mutual fund that does that.

The plus point in mutual funds is that they effectively diversify risks because they are putting your eggs in many more baskets (on average 40 investment positions, versus 8 or 10 for ETFs).  Diversification of risk is important, and to pay to get it is totally worth it.

My recommendation would be to use two core mutual funds as the foundation of your portfolio: a dividend fund and an index fund, and then add emphasis on sectors using ETFs.

Happy Investing!

(Need specific advice? Leave me a comment, I’ll be happy to help)

4/11/2013 08:19:20 pm

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