Joel Dickson answers more of your questions on ETFs
April 17, 2014
Vanguard investment experts Joel Dickson and James Rowley were guests during a recent hour-long webcast on separating fact from fiction when it comes to exchanged-traded funds (ETFs). But with more than 4,500 questions from the audience—some of which are addressed in these these brief video highlights—it wasn't possible for our panelists to answer each one. We sat down with Mr. Dickson afterward and asked him to address some of the most common questions we received.
What are some of the more subtle similarities and differences between ETFs and mutual funds?
Joel Dickson: Well, both offer an open-ended structure. This allows new shares to be created and existing shares to be redeemed every day. With mutual funds, investors can interact directly with the fund company to create and redeem shares at the daily calculated net asset value (NAV).
ETFs also have this daily creation and redemption feature, but there are two key differences. First, only certain institutional investors can create and redeem shares directly with the issuing ETF company at a daily NAV. Second, these institutional investors can transact only in large amounts of ETF shares called "creation units"—usually 50,000 shares or more—as opposed to individual shares.
So most ETF investors trade the shares created by these large institutional investors on an exchange at what's considered a fair market price between the buyer and the seller. ETF market prices generally are close to the fair value of the securities in the ETF's portfolio, because the large institutional investors who interact directly with the ETF can mitigate any premiums (prices above NAV) or discounts (prices below NAV) by:
- Buying the underlying securities of the portfolio, selling or shorting ETF shares, and then delivering the underlying securities to create new ETF shares at the end of the day to close out the positions, in the case of a premium.
- Buying ETF shares and selling or shorting the underlying securities and then redeeming the ETF shares to receive the underlying securities at the end of the day to close out the positions, in the case of a discount.
Thus, the open-ended nature of ETFs also allows the end investors to transact at close to or roughly equal to fair value.
Do ETFs pay dividend and capital gains distributions like mutual funds?
Joel Dickson: Basically, yes. More than 90% of ETF assets are structured under the same regulations that govern traditional mutual funds and, therefore, fall under the same tax rules. If the underlying portfolio of a fund or ETF generates income or capital gains, it must distribute them to its shareholders. So it's a myth that investors avoid capital gains until they sell shares of an ETF.
So are ETFs more tax-efficient than other investments?
Joel Dickson: I think it's really important to define tax efficiency. It's not just the amount of capital gains distributions; it's the after-tax return on an investment, which includes pre-tax returns, costs, and all taxable distributions. Focusing just on capital gains distributions may not give a complete indication of an ETF's overall tax efficiency. And historically, most ETFs have been tax-efficient because they track an index, which can mean there is less buying and selling within the portfolio compared with traditional active management. Low turnover usually means fewer distributions from the fund.
What about the "in kind" transaction process? Does that reduce taxable distributions?
Joel Dickson: It can. This is when large institutional investors are paid in stocks or bonds for a transaction rather than cash, which can reduce the tax liability of the fund. But as an individual investor in an ETF, you'd never receive securities from a transaction—they're always done through a broker and are settled in cash. While ETFs often make more use of the in-kind process, regular mutual funds can use it too.
Are there any differences between how an ETF and a mutual fund reinvest distributions?
Joel Dickson: Yes, and it's primarily how and when they're distributed. If you choose to reinvest distributions, gains are reinvested at the end-of-day NAV on the ex-dividend date with a mutual fund. With ETFs, an investor's broker typically reinvests distributions by buying ETF shares on the payable date (usually several days after the ex-dividend date), at the market price during normal trading hours.
We had many questions about premiums and discounts and how ETFs compare to closed-end funds. What should investors consider when buying or selling shares in a closed-end fund?
Joel Dickson: The first thing is that closed-end funds are just that—closed. The fund issues a fixed amount of shares, so you have to find someone willing to sell his or her shares before you can buy them. Since the number of shares is limited, large institutional investors can't step in to create or redeem shares, which could lead to shares selling at a premium or a discount. This is why you often see large deviations from NAV in closed-end funds, as the price is affected by the supply and demand for shares in the market in addition to the underlying value of the portfolio.
Please share your thoughts on equal-weighted index ETFs versus market-weighted ETFs, and why Vanguard is staying with cap-weighted indexing.
Joel Dickson: The whole idea of an index-based investment strategy is to track the returns of a specific market or market segment, as represented by a benchmark. The weights in a capitalization-weighted index are calculated using the market price multiplied by the number of outstanding shares (for stocks). As such, cap weighting reflects the market's consensus value of each security, using prices at which a buyer and a seller have agreed upon to exchange shares.
The idea behind some of the newer weighting approaches is that they might be better than the cap-weighting system because of certain perceived biases in market prices. But alternative weighting—be it equal weighting of securities or some other formula based on fundamental characteristics like earnings, for example—introduces its own assumptions about the market.
Many alternative weighting approaches introduce a value and/or small-cap bias to the portfolio relative to a market-cap representation of that benchmark. This is just another way of automating a view that certain segments of the market are consistently mispriced. If one believes a group of securities are mispriced, we think that represents an active, not an indexed, view because it means that the consensus prices where buyers and sellers have already agreed to transact (i.e., market cap) are wrong. This isn't necessarily bad, however, since such strategies may be provided at a lower cost than traditional active management.
We view market-cap indexing as the "beta" representation of asset classes used to access different markets. We believe that comparisons of alternative weighted index approaches to traditional market-cap weighting is similar to the evaluation of index versus active—namely, trying to assess the potential for outperformance and/or lower risk.
- All investing is subject to risk, including the possible loss of the money you invest.
- Vanguard ETF Shares are not redeemable with the issuing fund other than in creation unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
- Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
- This article is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.