Webcast replay: ETFs: Separating fact from fiction
April 17, 2014
Replay and transcript from a recent Vanguard webcast
Though exchange-traded funds (ETFs) have been on the investment scene for some time, they remain a mystery to many investors. In this live webcast aired March 27, 2014, Vanguard investment experts Joel Dickson and James Rowley dispelled some of the myths about ETFs, detailed how they work, and explained how ETFs can be part of a low-cost indexing strategy for any investor.
Amy Chain: Well, good afternoon everyone and welcome to this live Vanguard webcast. Regardless of how you're viewing us, whether it's from a computer, a tablet, or a smartphone, we're so happy to have you with us today.
I'm Amy Chain, and today we're going to talk about exchange-traded funds, popularly known as ETFs and how they can fit into your portfolio. We also want to dispel some of the myths surrounding ETFs and tell you what they are and what they aren't.
After viewing today's webcast, we hope that you'll have a better understanding of potential advantages of investing in ETFs, how ETFs have sometimes blurred the lines between active and passive investing, and also why ETFs and traditional mutual funds aren't an either or proposition.
With us today to discuss this unique investment vehicle are two experts in the field. We have Joel Dickson and Jim Rowley. Jim and Joel, thanks for being here.
Joel Dickson: Great to be here.
Jim Rowley: Great to be here, Amy.
Amy Chain: Over the next hour or so, Jim and Joel will offer their insights on ETFs and give us a sense of how and why ETFs can be a good fit for your portfolio. But as always, today is about you and your questions and we already have many to choose from. We'll spend most of the broadcast answering those questions and we'll continue taking them live throughout today's event.
You can also send in your questions to Twitter by using #VGLive. That sound good?
Jim Rowley: Great.
Joel Dickson: Great.
Amy Chain: Now, ahead of today's webcast, we have already received a lot of questions, thousands in fact, and after looking through them, it's become clear to us that we can best help you, our audience, by spending some time covering the basics of ETFs at the outset of our webcast.
So, we're going to start simple today and then we'll build from there. Does that sound like a good approach?
Okay, so Joel, I'm going to just come right to you then. We're going to start with a question that we got ahead of time. This question came in from David from Wyoming, Ohio. David, thanks for your question to get us started here today. David wants to know, "What exactly are ETFs?"
Joel Dickson: Well, for all of the discussion about ETFs, actually it's pretty simple and pretty straightforward in many ways which is that much like a mutual fund, it is a way to get access to an investment strategy or an investment approach, and it pools a number of different investors. That is, it brings a number of different investors and their money together, and you purchase—or in different ways you purchase—underlying securities and you get the return of that underlying investment. So in many ways, it's a vehicle for investing just like a mutual fund might be, and you have stock vehicles, you have bonds. You might have commodities and so forth. So, they're very similar to a mutual fund in that regard in providing access to an investment strategy.
What I would say is sometimes we hear people talk about ETFs as if they're their own asset class and they're not. They're a wrapper for an investment strategy, and that's ultimately what you're getting is a portfolio of securities.
Jim Rowley: And I think what we're going to reiterate a little bit is as time goes by today is we hear the benefits of ETFs, right? We always hear about diversification, low-cost, tax efficiency. But I think what we want investors to understand is those are really the benefits associated with indexing and that those benefits that you get are not necessarily because of an ETF. They're benefits of indexing, and ETFs are a way to get access to indexing.
Amy Chain: We're going to spend a lot of time talking about that today, and maybe we could also just quickly hit on what makes an ETF different from a traditional share of a mutual fund—highest level.
Jim Rowley: I think we discuss this often and investors would be surprised to know how similar ETFs are to mutual funds. And Joel just mentioned a lot of them, that they're pooled investments that have a professional investment advisor. But investors should be aware there's really two big differences.
For all the similarities, it comes down to two main differences, and that is with a mutual fund investors transact directly with the mutual fund. And you might do that through a financial intermediary or some type of advisor. But you're really acquiring shares of a mutual fund directly whereas with an ETF, you trade those shares on an exchange; you acquire them with some other market participant.
Now, the other difference being with a mutual fund, you get your trades executed at the net asset value at the end of the day, and with an ETF you get that at a traded market price.
Joel Dickson: Yeah, and then net asset value being the value of the securities in the fund at a particular time, usually 4 p.m., Eastern time. To sort of build on that difference for just a moment, it's the investor experience that can be a little bit different, and people that are investing through an ETF probably need to understand some differences between investing through a mutual fund.
So, in mutual funds, typically the transaction is done in dollars, whereas in ETFs, it's usually done in number of shares. The timing of the trade, you know, if you put a trade in at 10 p.m. for a mutual fund or 2 p.m., you'll get the next 4 p.m. price. With an ETF, you're going to get the market price sort of immediately after you input the trade depending on—and we'll get to—how you input the trade. But the timing of the trade can make a big difference in terms of the ability to get a good execution on that ETF trade.
And then, there can also be some other differences like, for example, Vanguard mutual fund shareholders, and we've heard plenty of discussion about it, will often tell us or give us feedback about our frequent-purchase or frequent-transaction policy.
Well, with an ETF, there often isn't the same restrictions around transactions because one of the structural differences is that through the ETF, often it's set up in such a way that the transacting shareholders—people that are buying and selling—their activity gets sort of segregated or separate from the total underlying portfolio of existing investors.
Amy Chain: Great, so at the highest level, I hear you saying that the two main differences are one, trading. Mutual funds are priced and trade once a day, whereas ETFs trade throughout the day a little bit differently. And also, they're created differently, so they come to market in a little bit of a different way. We're going to spend a lot of time talking about some of that, so audience file that away and we'll come back and talk about that in a little bit.
But for now, what we want to do is find out if anyone in our audience is in fact, today investing in ETFs. So, viewers, you should see a poll question appeared on the right-hand side of your screen and that poll question is, "Are ETFs part of your investment portfolio?"
So, go ahead and weigh in now. If you can't see the polls, check your browser's zoom setting, and make sure it's set at 100%. We'll give you a few minutes to weigh in and in the meantime, Jim, I'd like to toss another question to you that came in from an audience member leading into today's webcast.
Greg from Portland, Oregon, has asked us, "Virtually every time I read an article recommending a fund to invest in, it's always an ETF, not a traditional mutual fund. Why have they become all the rage?"
Jim Rowley: I think one of the reasons for the rage is we've seen a lot of popularity in indexing in general over the past several years, and you think about the benefits that indexing provides. I've mentioned broad diversification, low-cost, they're tax-efficient. I think what you've had with the advent of ETFs, there's just more choice in terms of the number of different indexing-type strategies that you can gain access to, right?
We've seen more if you want the broad U.S. stock market, but maybe investors are looking for small-cap stocks or they're looking for corporate bonds or they're looking for emerging market stocks. You think about ETFs and there's just more of those types of different indexing strategies. There's more choice, so it's not that the mutual fund isn't a good way to do it. There's just more of them available in the ETF space.
Amy Chain: But as Joel said at the outset, ETFs are in a different investing class. It's a different door into the same strategy as a traditional mutual fund might be. Is that right?
Jim Rowley: And that's the point. It just so happens that there's just more of them available in ETFs. It doesn't make them different or better. It's just giving the choice; I just have more choices in the ETF space.
Joel Dickson: And I do think there's some element of, "We have a brand new shiny toy that we want to play with right now." Actually, many times when we talk about the ETF and mutual fund comparisons, I often like to flip it around and say, "Well, if ETF had been the standard for the last 30 years, and we now have this new thing come on board called a mutual fund that allows for frequent purchases, that is done at a price where it's the value of the securities instead of maybe deviating a little bit from the value of the securities, we would we be looking at that and saying, "Hey, that looks like a really attractive vehicle."
So, I think some of it is just there are some differences that actually can provide for many shareholders some benefits over what they see in terms of traditional mutual funds. That's not to say, though, that there aren't benefits on the other side which is why these discussions about mutual fund or ETF are almost never either or, but sort of what set of features and conveniences do you want in terms of making it easy for you to invest?
Amy Chain: So, let's talk a little bit while we're waiting for our final audience results to come in. Let's talk a little bit about why they're all the rage. So, I know you guys have done a blog post somewhat recently. I think it was earlier this month talking about some of the hyperbole that surrounds ETFs. Let's talk about what makes the headlines and then what might be some of the truths about ETFs.
Jim Rowley: Well, we're happy to come up with the blog post and we liked our type of Groundhog Day, right, for those that are familiar with the movie because the idea was that there were a lot of these concepts that kept coming up over and over and over that we wanted to make sure that we addressed.
Some of them we have talked about here already, and there's other issues that some of it was the "shiny new toy" syndrome. It was just, "Oh, there's this new product and I can buy it and it trades on an exchange," and the point of our blog from mine and Joel's perspective was to remind investors, "Let's focus back to some basics." If we're talking about ways to access an investment strategy, most of which are indexing-based strategies. So, before we get all excited about this new thing called an ETF, and it's great and it's better, let's remember, "What are we talking about?" We're talking about acquiring an investment strategy, most of which is indexing.
So, get to know what that investment strategy is. How does your manager execute upon that strategy? Can you acquire that strategy at a low cost that we so dearly believe in at Vanguard?
Joel Dickson: Is it right for your portfolio, ultimately, in what you're trying to achieve. One of the big points that we make in that that feeds through all of this is that often comparisons are made at the highest level between ETFs and traditional mutual funds, whether it's cost, whether it's tax efficiency. And as Jim has already mentioned, that sort of obfuscates a bit the issue of that in the traditional mutual fund space, about 85% of the assets are in what we would call "actively managed strategies" and about 15% are index-based strategies.
Well, in the ETF space, it's more on the order of about 95% to 97% of the assets are indexed-based. So, are you making a comparison between ETFs and funds, or are you making a comparison between index and active? And that's a lot of times where I think the discussion of the relative benefits and merits gets confused.
Amy Chain: I think that's a really important point. I want to spend some time on that a little later in the broadcast today. But for now, our poll results are in, and in fact it looks like roughly half, a little more than half, have said that they're either not invested in an ETF, or they're not yet, but they're thinking about it. So, about 1,600 of our viewers today have said, "I'm in one," and everybody else said either "No," or "No but I'm thinking about it." Does this surprise us?
Joel Dickson: You know, it does surprise me a little bit that it's that much among what has largely been a retail audience because in some ways the retail direct investor has been the last to the table, if you will, from an ETF standpoint. ETFs started in the institutional trading community, as a way to hedge and transact in some more efficient ways, and then has moved into the financial advisor community in a big way over the course of the last decade and really is just starting to get penetration into the retail direct space.
So the fact that it's a little less than half, but only a little less than half, does surprise me because if you look at ETF penetration throughout the U.S., I think the Investment Company Institute has, in its most recent survey, it's on the order of 4% or 5% of U.S. households invest in an ETF. That is much, much less than traditional mutual funds— much higher penetration of traditional mutual funds in U.S. households.
Amy Chain: That actually leads nicely into another question that we got leading into today. And this question comes in from Brian in Royal Oak, Michigan. And Brian says, "A lot of money has moved into ETFs. Are they replacing traditional mutual funds?"
Jim Rowley: I don't think there's anything to fear, to worry about them replacing traditional mutual funds. I think what we aspire to is that investors are gravitating towards low-cost indexing. We've actually shown some statistics in a Vanguard paper called Costs matter, and we've shown that over the past decade or so, investors have put more of their cash flow, or put more of their money toward those investments that cost less, whether they're index or active.
And I think you see also over that past decade, there's been an increasing amount of investors investing in indexing vehicles. So you put the two of them together, where there's been greater awareness of indexing. There's been greater emphasis on low costs. And we see ETFs as a part of that wave, and to the extent inventors start to use them more going forward, that's just another way to execute upon low-cost indexing.
Amy Chain: So the tailwinds behind indexing have helped to drive ETFs' popularity.
Joel Dickson: There's also been some new markets that have been opened. I mentioned financial advisors as a source for usage of ETFs, and in fact, over the last decade there's been a big trend in the financial advisor community towards what's called "fee-based advice," which is basically separating what you pay for advice and the underlying investment costs. And so there's been a focus on low-cost investment vehicles in use in those fee-based approaches. And ETFs have actually fit nicely into a market that before really did not use a lot of low-cost and, in particular, low-cost indexing approaches in the investment options in an advice program.
Amy Chain: That's a great point. Let's stay on the topic of costs and throw another question out to our audience. So viewers, we're coming to you with a second polling question. It should be appearing on the right-hand side of your screen, and the question is, "Which of the two types of investments shown below have lower costs?"
So we're starting to get into our fact versus fiction portion of our broadcast today. We'll see what the audience thinks about that question. But in the meantime, I'd like to answer another question that came in from our viewers before today's event. This question comes in from Paul. Paul's from Pittsboro, North Carolina, and Paul says, "What are the fictions of ETFs? I happen to own a few." So let's start talking about some of the fact versus fiction.
Joel Dickson: I think a number of them we've already talked about which is, are we really talking about ETF or are we talking about, for example, ETF versus fund, or ETF as its own investment vehicle. Or are we really talking about index versus active, or low-cost, or getting access to an investment strategy, so all of these types of things.
I often will say that the "F" in ETF stands for "fund." And remembering that there are actually a lot more similarities with things that, especially our clients, already know which is the mutual fund structure and then getting access to an investment program through that.
So, I think a lot of times, the differences that really come down to—the trading type differences between ETFs and traditional mutual funds—have been highlighted to such a point that it makes it sound like it's a completely different and new investment, when in fact it's really just a repackaging of what already exists.
Jim Rowley: And many times, when we talk to investors and some of our clients, we often make the suggestion, the next time you see a big headline banner about the benefits of ETFs, I say, "Hey, let's challenge that. If you delete the letters 'ETF' and replace it with 'index fund,' do those principles and benefits still apply?" And in a lot of cases, they do still apply.
Amy Chain: Let's spend a minute and talk about that while we wait for our poll results to come in. Actually, another question came in from Michael from Spotsylvania, Virginia. Michael, thank you for your question. And Michael wants to talk about some of the expense ratios on mutual funds and ETFs. I want to talk about expense ratios between index funds and active funds, and then maybe we can bring that into ETFs later. Because that's really the question here, right?
Jim Rowley: Yeah, I mean, actually, you've made the first cut that we always talk about, right? You see the headline discussion is always, "Oh, the expense ratios for ETFs are much lower than expense ratios for mutual funds." And what we prefer to do is say, "Okay, but now let's sort of reorganize those categorizations," and say, "If I take ETFs and break them into index and non-index, and I take mutual fund expense ratios and I break them into index and non-index, now all of a sudden you see the expense ratios of the two index products to be much more similar than the two when you look at them through the non-index lens." So as Joel's mentioned, this again is not a case of ETF versus mutual fund, but index versus non-index.
Joel Dickson: I think it's also important, though, because there are these other costs that come into play for an investor when they're trading ETFs. I think a lot of times people will think of the expense ratio as the cost that they pay in a mutual fund, and while there are some other costs that show up in the form of the net asset value, people think of, "Well, I'm paying the expense ratio, and that's pretty much it" in the mutual fund.
With the ETF, there's still the expense ratio or the management fee that gets paid on the underlying investment, but there's also then the transaction cost that you pay in trading these, whether it's a brokerage commission or other forms of costs, that we'll talk about when we talk about trading, that have to be thought about in the total cost context.
Amy Chain: That's great. Want to hear what our audience had to say?
Jim Rowley: Yeah.
Amy Chain: Okay. So, the most popular answer was, "It depends." So, kudos to you, audience. That was the right answer. But we actually had almost 10% of folks that said they thought mutual funds were lower cost, about 30% said ETFs, and then the rest were split between "It depends" and "I don't know." I think we're probably pretty pleased to hear that everyone said "It depends" because that's where we were headed, right?
Jim Rowley: Yeah, absolutely.
Amy Chain: Anything we want to add on to that question before we jump into some more audience questions?
Jim Rowley: Leave on a good note.
Amy Chain: So let's take a question. I think we actually had a live question come in while you two gentlemen were talking. So let's get to Paul's question. Paul asks, "What are the pros and cons of actively managed accounts versus ETFs? I'm getting hit with a huge tax bill this year because of substantial gains and wondering if ETFs are a better way to go."
Jim Rowley: Boy, I'd love to just go back to what we've been talking about the whole time is if you think about capital gains being triggered, usually because of turnover in a portfolio. Going back to it's not about ETFs; it's about indexing, right? We know indexing is a lower-portfolio-turnover strategy relative to actively managed funds. So, I'd like to say, yes, there are benefits to ETFs: their low portfolio turnover, and perhaps they trigger less in the way of capital gains, but a lot of that has to do with because they're index funds.
Amy Chain: So the answer to the question is, "Should I be thinking about indexing, and if so, should I consider ETFs as a way to index?"
Joel Dickson: Possibly, and again, one of the things, though, is this isn't so much an ETF question, but an investment issue, which is, "How do you divest yourself of a tax-inefficient investment?" And it may not actually make sense in all cases to just sell that tax-inefficient investment and buy another one because while you may not be getting capital gain distributions, you will have generated a capital gain yourself, potentially, by selling that vehicle.
So, you kind of have to do an analysis of, "How much would it cost me? You think of taxes as a transaction cost to actually rejigger my portfolio, and is it worth the benefit that I would pick up?" And that's where a financial advisor or a tax advisor could potentially help with part of that.
But certainly if you're looking for a—at least the hope or the expectation of—a more tax-efficient vehicle going forward, then a broad-based type index portfolio has at least shown characteristics of potentially doing that. And can you think about that as maybe a strategy in taxable accounts or there are many different ways to access that. And then it's a question of, whether there are features of the mutual fund or the ETF that you might prefer and therefore make an assessment on that basis.
Amy Chain: Do we want to spend a few minutes talking about what some of those considerations might be between an ETF and a mutual fund, a traditional mutual fund?
Jim Rowley: I think the first one that really comes to mind is when you, the investor, go to transact, right. So, you've discussed what investment strategy you want and where it fits in your portfolio, but now comes the moment of transaction. And for most mutual fund investors, you're very comfortable with putting a dollar amount when you order, and frankly you could put the order in at any time of day, right. You can log on to your account Saturday morning if you want and place an order. But with an ETF, you're starting to now realize, I need to place my order in number of shares, not a dollar amount.
Amy Chain: And let's pause and talk about that again because traditional mutual fund shares are priced one time per day during business days when the stock market is open versus an ETF which is traded throughout the day, much like a stock, and the prices of the underlying securities can vary throughout the day. Right?
Jim Rowley: Yes.
Joel Dickson: Yeah. And that gets back to thinking about how you transact because, to Jim's point, if it's the week-end, and I know I want to make a transaction, I can go in and do it for the mutual fund, and I know I'm getting the 4 p.m. price on Monday, if Monday's a business day.
Then in the ETF, though, often that type of order, if you were to put that in on a Saturday night, it would get executed if you put it in as what's called a "market order," which is basically just, "Execute the order for me." It would get executed first thing on Monday morning when the stock exchange opens. Often for ETFs that is not a very good time to actually place an order because an ETF also represents the value of its underlying securities. And because not all of the underlying securities have yet opened for trading, what we call "the spread," that a market-maker who is facilitating the transaction is going to require for their own risk purposes, is often higher, because there's more uncertainty about where those underlying stocks are going to trade when they do open. So doing a market order that executes on the open often is not necessarily the best execution approach.
Amy Chain: So we're heading into a sort of ETFs 201 conversation quickly.
Joel Dickson: Yeah.
Amy Chain: But maybe we could just pause for our audience and talk about some of the terminology that comes up when you talk about this. So you mentioned a spread.
Joel Dickson: Yeah.
Amy Chain: Talk to us about what spread means
Joel Dickson: So, the spread is essentially—it's called a "bid-asked spread"—it's essentially the profit that a market maker that's facilitating a transaction between a buyer and a seller, is going to charge in order to facilitate that transaction. I mean, to a certain extent, think of it as your grocery store. So your grocery store is getting corn from a farmer and you are going there to buy it, and there's a price at which that transaction occurs that includes a little bit of a profit for the grocery store and then the cost of the goods to the farmer, right. So there's the cost of the goods, namely the underlying securities of the ETF, and then there is the spread that the market-maker has for their profit to facilitate the transaction.
Amy Chain: Great, thank you. I'm going to ask for another quick definition. Jim maybe you can give it to us, we haven't talked about it yet, but if it comes up everyone will know what we're talking about. Let's talk about premiums and discounts.
Jim Rowley: Sure. We can start with net asset value because hopefully most everybody's familiar with what that means, but when you look at an ETF, the premium or discount is simply the difference between the traded market price and, to make things easy, the most recently observed net asset value of the ETF.
Amy Chain: So net asset value is the same as the—
Jim Rowley: Value.
Amy Chain: The value of—
Jim Rowley: Exactly.
Amy Chain:—a share of what?
Joel Dickson: Of the underlying securities in the portfolio, so if it's the S&P 500 Index it's the underlying value of each of the 500 securities in the Index in their appropriate weights.
Amy Chain: Okay.
Jim Rowley: And the premium is just simply if the price—the market traded price, the ETF—goes above the net asset value; we call that "trading at a premium." And if the traded price falls below the net asset value, then we consider that "trading at a discount."
Amy Chain: Okay, we'll come back to some of these 201 topics a little later in our hour here, but we have a few live questions that have come in. Shiresh from Georgia wants to talk about how to select an ETF, and the question is, "How do you select an ETF and diversify?" So let's talk about the different reasons why you might pick an ETF and then how it might fit in to your portfolio.
Jim Rowley: Top of mind becomes, "What are your portfolio objectives?" I think our starting point would always be, "What's the investment strategy that you're seeking," right? It shouldn't be, "I want an ETF because it's an ETF." It's "I'm doing good old-fashioned portfolio construction and whether or not it's a mutual fund or an ETF, what's the investment goal that I'm trying to accomplish?"
Again as we talk about at Vanguard, "What are my costs to implement that investment strategy?" Whether it's the expense ratio of the fund, the product that I'm buying, or the transaction costs associated with "I'm going out and acquiring or selling shares of that product."
Amy Chain: So first you have to rewind and say, "What is it that I'm trying to do with my portfolio? What's my risk tolerance? What's my asset allocation? Do I want stocks, do I want bonds, and in what percentage?"
Joel Dickson: And then how best to implement that. Let's just take a simple cost example. Let's say you've decided that you want some equity exposure in your portfolio, and you have a choice between a mutual fund approach and an ETF approach—and at Vanguard they actually represent the same portfolio of underlying securities. Well if you have less than, for example, $10,000 to invest, you may be in what's called our Investor Share class, which may be higher cost in terms of expense ratio than the ETF Share class. But if you have $10,000 or more, you may be in the Admiral Share class which has the same expense ratio as the ETF Share class. So just that difference in of itself could lead to a different conclusion.
Amy Chain: And so we're back to the door. So you know this is where you want to be; which doorway do you want to take to get into it.
Joel Dickson: Yeah, and then it comes down to the things like, "Well what's the overall cost, including the transaction costs of either the mutual fund or the ETF? What are the set of features that are there?" With the ETF, you do have some trading flexibility in terms of being able to trade throughout the day, if that is valuable to you, instead of having to wait for the 4 p.m. pricing.
On the other hand, on the mutual fund side, you often have convenience features like being able to move money directly from your bank account directly into the mutual fund on a set schedule, and that's a little more complicated, in most cases, with an ETF where often you have to put it into your money market account, and then put a trade in and shares so forth.
Amy Chain: Well that opens an important question. An ETF would have to be held in a brokerage account.
Joel Dickson: Correct.
Amy Chain: Maybe we could talk a little bit about the mechanics of what that means. You just alluded to one of them. Maybe we could just reiterate.
Joel Dickson: The brokerage account is familiar to many, many investors, but it is a little different than the traditional mutual fund account, and again it gets back to these things like you're usually transacting in shares rather than dollars. And you have to put a trade in often from a sweep account or a money market account that is funding that. So, doing exchanges and transfers, and automatic investment and automatic withdrawals often requires an extra step in the ETF space.
Amy Chain: Good, Jim, anything to add?
Jim Rowley: I think maybe we're going to get back to the 201 a little bit with this, but at that point of when you hit the send button on your screen, it's probably a simpler experience with a mutual fund that you say, "I want $5,000," you hit go. With an ETF when you're transacting in shares—I think Joel mentioned earlier this concept of market pricing—and you just get transacted at the next readily available agreed-upon price in the market.
We actually advocate for what's called "limit orders." And what a limit order means is you're putting your order in through your brokerage account, but rather than saying, "Give me whatever the recently readily available market price is, I'm setting the price limit," meaning "I don't want to pay any more than such amount of money."
Amy Chain: This is the most I'll pay for this ETF today, this share of the ETF.
Jim Rowley: Right. Or if you're selling, I don't want to sell it at anything less. Now your trade-off with this is at a market price you're pretty much guaranteed to get that executed, but it might not always be at the price you prefer. Whereas with a limit order, you are guaranteeing the price at which you'll get executed, if you get executed, because sometimes the market might not meet that particular price.
"All around the ETF industry you can get different types of index products that sort of cut the market down into more narrow and more narrow and more narrow slices. Not all indexes are extremely broad-based ... and some seem more akin to an active strategy. So as an investor, please read into what that construction methodology is, because you need to "know what you own."
Joel Dickson: I do actually want to go back to the original question for a minute about, "How do I evaluate an ETF?" To get back to it, it is about evaluating the underlying investment strategy. And there may be cases where that strategy that you want access to is only available in an ETF form. Now would we say that you're then investing in an ETF? Well, yes, physically–
Amy Chain: You're investing in a strategy via an ETF.
Joel Dickson: Where an ETF is the only available vehicle to access that strategy.
Amy Chain: And that gets to the point you made earlier about there's potentially more variety out there in terms of ETFs, so you might have access to more strategies.
Joel Dickson: Certainly in terms of indexing-based strategies, yeah, that's true.
Amy Chain: But again to get back to a point that you just made, at Vanguard anyway, our ETFs and our traditional mutual funds are the same portfolios, so if it becomes a decision about, "Do I want to buy this way or buy this way," but you ultimately end up with the same investment at the end of the day.
Joel Dickson: That's right.
Jim Rowley: Yes, and I think we're usually very happy to say—because we get the question very, very often—is "Well, which one is right for me?" Joel and I will say, "Well, we can't answer that for you." We are thrilled that clients come to Vanguard to get their indexing access, but for every investor they might have their own unique circumstances that determine for them which one of those two types they prefer.
Amy Chain: And we do have a fair amount of information available on vanguard.com that helps investors, at least at the highest level, start going down the right path for which might be right for them.
Joel Dickson: The only thing I would reiterate is, think about it first from the portfolio construction basis: "I'm wanting stocks, I'm wanting bonds, I'm wanting whatever the asset class or sub-asset class is," then figure out whether it is mutual fund or ETF to gain access to that that makes more sense as opposed to going in and saying, "Oh, I want an ETF that does this" because that may actually not be the full answer.
Amy Chain: That's a great point. Okay, let's take another live question. This question comes in from Thomas from Traverse City, Michigan. Thomas, thanks for watching today. Thomas says, "I understand that some ETFs do not structure their indexes uniformly; is that correct?"
Joel Dickson: I'm going to guess, I'm going to take this to talk about the indexing approaches that have occurred with ETFs. Historically, when we have thought about indexes like the S&P 500 Index or Total Market Index on the equity side, or international equities and so forth, it's referred to as what's called "market-capitalization weighted," so the largest stocks have the largest weight.
That basically reflects the consensus prices in the markets of where people have agreed to transact. If Apple is at a particular price, that's where a buyer and a seller have agreed to transact, so it's the market clearing prices. And that's usually the benchmark that people think of for whatever the asset class might be.
What we have seen, especially in ETF investment strategies, is alternative ways of building indexes that may weight securities differently. A simple one would be instead of market-capitalization weighting you equal-weight all the securities, so if there are 100 securities, they each get a 1% weight in the portfolio as opposed to their market-cap weight.
Amy Chain: Let's just pause again real quickly and put it into the context of we're not talking about ETFs versus non-ETFs right now; we're talking about indexing and investment strategies. Forget the doorway into the strategy. Let's talk about what these different strategies are.
Joel Dickson: That's right. The only thing I would add to that is the doorway for a lot of these alternative indexing strategies may be more restricted to the ETF door than it is to the mutual fund door.
Amy Chain: But it's the doorway in?
Joel Dickson: That's right. It's not the strategy itself. But what these underlying alternative weighted strategies are basically saying is that we have a view that the prices that the market has set in the market-capitalization weightings are wrong, or that we think there is a different way to potentially generate either lower volatility or higher return or so forth. There might be a more efficient way of weighting these securities.
Well if you believe as an investor that some segment of the market is mispriced relative to what the market has said the prices are, our view of that is that sort of is by definition an active view. You're saying that the prices are wrong.
Amy Chain: Sounds like an active bet. Right.
Joel Dickson: While they're definitely being created as indexes, and they're being run in how they're being implemented as an index, the underlying index itself often reflects an active tilt or an active risk being taken relative to the market.
Jim Rowley: And either way whether they're talking about market-cap-weighted indexes or non-market-cap-weighted indexes, this still comes back to the classic "know what you own" phrase because even on the market-cap-weighted indexing side, there are some that are extremely broad-based.
We know at Vanguard, we have a Total Stock Market Index or Total Bond Market Index, but all around the ETF industry you can get different types of index products that sort of cut the market down into more narrow and more narrow and more narrow slices. Not all indexes are extremely broad-based, and then you add to this element of what we would consider to be an index that is more akin to an active strategy. So, as an investor, either way, please read into what those rules are or what that construction methodology is because it's "know what you own."
Amy Chain: Invest in a strategy, not the vehicle.
Joel Dickson: A lot of times we often talk about—and there was an earlier question about essentially due diligence: "How do I evaluate?" And when you're thinking about these alternative index approaches relative to market-cap-weighted, think to yourself, "How would I evaluate this? Am I evaluating it by how much risk or return expectation I'm expecting, or am I evaluating how the manager implements the index fund—things like what we would call "tracking error" and "excess return" relative to the benchmark."
And these alternative weighted strategies—although again they've been put into index form—everyone talks about how to evaluate them as if they're an active-type strategy. That is, "What’s the philosophy? What does the portfolio look like? What's the process? And do I think that will generate some form of excess return or lower risk or so forth over time?"
Amy Chain: Great. Take another question. This question comes in from Chris from Owatonna, Minnesota. Thank you, Chris, and I said it correctly. "What's the difference between an ETF and an ETN?"
Jim Rowley: Well the short answer would be, as Joel mentioned, the "F" in ETF stands for "fund." It's a vehicle, a pooled vehicle of securities within a fund. An ETN, which is a term for an exchange-traded note, it is a debt instrument. It is literally an IOU issued by a big financial institution that promises to pay the return on that underlying strategy, but you don't own any underlying securities; you own a note. You own an IOU backed by somebody's promise to make good on that investment strategy.
Joel Dickson: Basically you have credit risk. If the banking institution that is providing that promise were to go bankrupt, you potentially have a—there's nothing backing it other than the general assets of the financial institution.
Whereas with a fund structure and most ETFs, what we call ETFs, over 90% of the assets are regulated under the same rules that regulate traditional mutual funds, so you have an independent portfolio, it's segregated from either the management company or other investment portfolios, you have independent auditors, independent boards, independent directors, and all of those sort of additional protections that may not always exist with an ETN.
Amy Chain: An ETF and an ETN are two totally different investment vehicles?
Jim Rowley: Yes.
Joel Dickson: Yes, they are.
Amy Chain: Chris also asked about closed-end funds.
Jim Rowley: Close-end funds, a little bit interesting note because we talked about sort of the open-ended nature of mutual funds and ETFs, and closed-end funds are closed because they don't issue new shares. Now as it turns out, closed-end funds actually also do fall under the Investment Company Act of 1940, so they are regulated like mutual funds in that fund-type structure.
But where the difference comes in with mutual funds and with ETFs is they are open-ended. New shares can be created or taken away, but closed-end funds don't. They have a fixed number of shares that go out in the marketplace and although their underlying securities have an intrinsic value, or they have a net asset value, the price that you get as an investor can now be really dependent upon just the supply-and-demand forces for the closed-end fund, as opposed to what you see with other open-ended vehicles.
Joel Dickson: And ETFs fall under the open-end vehicles, and this is why, although there can be differences between market prices and net asset values as we've talked about in terms of the ETF, this open-ended mechanism where new shares can be created and redeemed actually is the way that the net asset value and the market price are often kept in line much more closely with each other than say in a closed-end fund where there's a fixed number of shares and you can get people fighting over the available shares that can move the prices sometimes substantially up or down from the underlying value of the securities.
Amy Chain: And to give context to our viewers at Vanguard, we offer open-end mutual funds and ETFs.
Joel Dickson: Correct.
Amy Chain: You can't buy a closed-end mutual fund from Vanguard.
Joel Dickson: That's correct. Well, you can buy a closed-end fund, but it's not sponsored by Vanguard.
Amy Chain: It's not a Vanguard closed-end fund. Thank you.
Joel Dickson: On a brokerage platform, there are closed-end funds available.
Amy Chain: Important note, thanks Joel. Let's talk to Carol from Warrington, Carol from Warrington, Pennsylvania, actually right around the corner. Carol says, "Please explain the cautionary note on Vanguard ETFs that states that they must be bought and sold on the secondary market with the assistance of a stockbroker. Must the investor find a stockbroker or is one available through Vanguard?" These are really two questions. Jim, why don't you start?
Jim Rowley: Right, I think that I'll address it in the literal sense. You see the phrase "stockbroker," we might chalk that up into a little more of disclosure requirements, that you need not purchase them with a physical human being stockbroker, right. If you have a brokerage account, which Joel mentioned before and we've discussed, your way to acquire an ETF is that you have to have a brokerage account.
So, you might not have a stockbroker "human being," but to the extent, you have a brokerage account, that's a reminder that if you want to purchase or sell ETFs, you must go through a brokerage-based facilitation.
Joel Dickson: I would just also add that her question was not the only one that we had on the disclosures on the invitation that was sent out for this webcast, which you always hope that disclosures are plain English, but that's how we really in some ways determine we do need to start at the beginning and think about, "What does it mean to talk about this secondary market, and so forth?" And that's that access issue; with the mutual fund, you're effectively interacting directly with Vanguard.
With the brokerage account, you're interacting through a different intermediary, namely the exchange. But all it means is that you have a brokerage account to do the transaction.
Amy Chain: Great. Anything to add? Okay, let's go to a question from Jerry from Illinois. Jerry says, "Please explain the process of submitting an ETF trade, and how much do trades cost?" So here we are back to it being a little bit of a different experience to buy traditional shares of a mutual fund versus exchange-traded shares. Perhaps a repetition of something we've already just said, but bears repeating.
Jim Rowley: Yeah, again we're starting with a brokerage window, and the basic difference is, right, where with an ETF you're not putting in your order in dollars; you're going to put it in number of shares. You need to recognize that we put the order in, where with a mutual fund you just know that you can walk away and you're going to get that price that every investor gets at the end of that day, that net asset value at 4 p.m. And with the ETF, you're going to get a price at that nanosecond that you put that order in—subject to the discussion we had about limit orders and market orders, but let's say within a reasonable time frame—you get to execute in real time as opposed to that NAV end of day.
Joel Dickson: And actually I don't want to gloss over this dollars versus shares thing that we've talked about because even from folks that I talk with—and I do work with some financial advisors that use Vanguard products, and we still hear this from some of their fund stories—that trade tickets were meant to be put in as dollars, but they were put in as shares.
So think if a fund is priced at $100 per share and you want to invest $10,000, that's 100 shares. If instead you put 10,000 for your order, you've just bought $1 million worth of that ETF. So, this is not uncommon, even among people that have some experience using ETFs. So this whole going back and forth between mutual fund and ETF—you need to be really careful understanding what the transaction is in.
Jim Rowley: I think that the additional part of that question was, "How much does it cost?" Assuming not the faux pas of a $1 million purchase but your actual cost to make this trade, the answer again is, "It depends."
If you're a Vanguard client, and you have a Vanguard brokerage account, you can buy and sell Vanguard ETFs with no commission. But if you were to buy a non-Vanguard ETF through a Vanguard account, there are brokerage commissions associated with it there; whereas there are other brokerage account providers elsewhere that there are arrangements where you would not pay brokerage commissions to purchase certain ETFs, but you probably would pay one with Vanguard ETFs.
So a lot of it has to do with the products that we're talking about and where those products are bought and sold on whose brokerage platforms.
Amy Chain: I think the important point there is to make sure you're checking to see if there are any extra commissions or charges for buying an ETF.
Jim Rowley: Yes.
Joel Dickson: That's correct.
Amy Chain: This question comes in from Doug from Iowa. Doug, thank you for your question. Doug says, "Are ETFs better for short- or long-term investors? How does the fee structure impact your investment horizon?"
Jim Rowley: Can we answer "It depends" again?
Joel Dickson: Yeah, most of these answers are, "It depends, doesn't it?" Actually, that's kind of in many ways the beauty of the ETF structure, where the transacting investors and their activity are segregated from the portfolio itself and the existing investors. So, short-term investors and long-term investors can peacefully coexist because neither is harming each other. At Vanguard we've turned away billions of dollars a year from people that want to hold some of our funds for a short-term period, and the reason is that that short-term holding period, the transaction cost of going in and then coming out at the portfolio level may actually be borne by all of the investors in the fund and not simply just the transacting investor.
With the ETF, the short-term investor now can invest in Vanguard's funds without costing the existing investors as much in terms of the actual transaction costs of being in and out in a relatively short period of time. That's why we don't have things like frequent-trading restrictions on the ETFs in the same way that we do for traditional mutual funds.
Jim Rowley: And I think I will boomerang us back to this "It depends" as part of the answer, right. We've talked about, you're trying to decide between an ETF and a fund from the standpoint of the investment strategy, and you work your way down your thought process. But this is a great question about, "Okay, well there are costs associated with this. And again, for every investor, it's going to be a unique experience because now you need to take into consideration, "How much am I purchasing? Is it a really big bulk purchase, or is it a smaller purchase? Do I see my time horizon as being really long versus really short? Am I making frequent intermittent purchases, or am I maybe making only three or four?"
And what you're going to weigh is the differences in expense ratios between the two types—an ETF or a fund—and you need to pay attention to what those recurring, what we call "transactions costs," are, right. A no-load mutual fund might be more simple if you have no ongoing costs to transact, but you are going to realize that in the ETF.
So every investor will have their own unique break-even analysis to do, and again that's not something we can necessarily answer; that's each investor's unique experience to determine which route is best for them.
Amy Chain: So, we're back to figure out what is the right investment, pick your right asset allocation, your right investment, and then decide which door to go through to get to it.
Jim Rowley: Yes.
Joel Dickson: Exactly.
Amy Chain: Another live question came in from Liz. Liz says, "What is the difference in potential capital gains on ETFs versus index funds?" Liz, I'm so glad you asked this question. We love this question. Who wants to take it?
Joel Dickson: So, this often gets to this question about ETFs talked about in the form of potentially better tax-efficiency. And again, a lot of this, we think, comes from the index strategy, especially when you talk about broad-based equity and exposures, that you get the tax efficiency from the lack of portfolio management that needs to be done in terms of maintaining relative to a broad-based index, and so, therefore, less capital gains.
But the "ETF versus fund" issue often gets talked about in the context of this concept. And it's a little bit of the—we'll go into the 201 concept here. With ETFs—not you as an investor—but underneath in this mechanism by which the net asset value and the market price, as I mentioned before, sort of stay relatively in-line, there's something called "ETF creation" and "ETF redemption" that are done by large institutional purchasers interacting with the fund.
When they transact, they do so with securities—what's called an "in-kind" transaction. So, with the S&P 500, they'll give us 500 stocks, we'll give them shares of the ETF or vice versa if it goes the other way.
And when transactions are done in-kind out of the portfolio— that is we give one of these large institutional players a portfolio of securities—you don't have to realize the gain that otherwise would have been realized from selling those securities at the fund level, and therefore it doesn't have to be distributed.
Amy Chain: You sort of net some things out from the fund level.
Joel Dickson: Yes, exactly. Now, that said, in the traditional mutual fund, we actually also try to manage those portfolios in a very tax-efficient way, which is when we get a redemption in a traditional mutual fund, which is, in that case, funded by selling securities at the fund level and paying in cash.
If a gain were realized there, you would have to distribute it to all shareholders in the fund. We often try to minimize that gain by selling what's called "highest-cost-lot securities," which is to try to minimize the taxes on any sales in the portfolio. So, you can sort of use both.
And we've talked about how with the ETF and the fund, they're the same underlying portfolio. The way that we manage that is we actually try to tax-optimize across these different share classes, realizing losses to the extent that we can when there's a redemption from the mutual fund and trying to sort of get rid of the highest-tax issues when we're doing the in-kind redemption.
Amy Chain: If I could just reiterate with a point that you opened with, I think that it’s really what you sort of said, when you read in the newspapers, ETFs are really tax efficient, try subbing that out and indexing is really tax-efficient. So it’s more of the strategy than the vehicle of that of the tax strategy.
Joel Dickson: The indexing strategy gets you a long way there. Some of the ETF structure can help, but I think as Vanguard has shown with our own index funds, we have not distributed a lot of capital gains on the equity side over the last decade, and that's not just because of the ETF mechanism. It's because of the market environment, the way that we manage portfolios, and the indexing approach.
Jim Rowley: And maybe just to add, let's not lose sight of what we would define tax efficiency to be, right? Don't go down the path of whether or not a fund pays a capital gain or it doesn't. What's more important is how much do you keep? So if you're invested in an index fund, what you really care about is, "How well does that fund track the index, and after I account for expenses and/or any taxes I've paid, how well am I tracking the index?" Because if you're in a fund that severely lags its index, and you say, "Oh, I paid no capital gain" well clearly I'm better off being with the product that maybe it paid a little gain with smaller expenses but that, when all that is said and done, I still tracked my index better.
Joel Dickson: And I think that it is important to highlight, even though we've highlighted some of the differences, the tax rules that ETFs, at least those structured as open-end funds as we've talked about, and mutual funds have, are exactly the same. To the extent that you have dividends or interest income that is received or capital gains that are realized, they have to be distributed to investors. There's no difference in the tax rules between ETFs and funds, at least, again, those structured as open-end funds.
Amy Chain: That's great. We're actually getting close on time. We probably have time for one or two more questions. Let's take a question from Philip from Minnesota. Philip asks, "Are ETFs as safe as the regular mutual funds they mirror?"
Jim Rowley: Well, we can go back to what we talked about with the regulatory environment, right. So, a couple ways to think about this is. Joel mentioned over 90% of the assets in ETFs are in those that are regulated by the Investment Company Act of 1940, as are our mutual funds. So from this regulatory framework, they fall under the same header. So we can talk about the safety of them, but from a regulation standpoint, they're subject to the same rules.
Amy Chain: They're handled the same way.
Joel Dickson: I think sometimes this comes about in terms of the safety of, let's say now the execution, and because investors own more of their execution in the ETFs, to the extent that you get a price that might be different than what you were expecting or different than the value of the underlying securities, there's where you have to be careful about how do you trade.
And as Jim mentioned earlier, using limit orders, maybe, instead of market orders. Knowing when to trade and maybe avoiding trading ETFs at the beginning of the day or at the end of the trading day. Those are things that can help in terms of if we define safety as in having good execution on those ETF shares.
Amy Chain: Great, do we have time for one more? I think we do. Okay, this is a question that comes in from Donna from East Williston, New York. Donna says, "Can you explain the premium discount to NAV for ETFs, and is there a way to evaluate that before purchasing or selling?" We touched on it a little bit. Let's close with a reiteration of these important phrases.
Jim Rowley: So "premium discount," again, we're talking about sort of the difference that you see of the market price of the ETF relative to its last stated NAV. And you'll typically not see much of any premium and discount in, say, domestic stock ETFs, because, quite simply, the U.S. stock market is open during a certain time frame, and domestic stock ETFs that trade in the U.S. are open over that same time frame. So as Joel was talking about these big institutions that make markets, they're setting prices for the ETF that are based upon the prices of those underlying stocks, and that's really easy. If you're open at the same time, it makes it kind of easy to do.
An example where you might see more premium and discount is with international stock ETFs because the time zone differences are askew. And if we think about stocks that trade in Asia and Europe, well those markets have closed, and they're all going to bed, and as we wake up and the U.S. market continues, we still have real-time news and information that causes investors to trade. And with an international stock ETF, those market-makers are making prices that say, "If those underlying markets were still open, like if Japan was still open, if Germany was still open, where would those underlying stocks be trading?"
In this case those prices are "stale," the phrase would be, in Asia and in Europe, but in the U.S. they're refreshed. So, we see premium and discount, and sometimes they get used in negative light, but all that really suggests is the market participants in the U.S. are putting prices on U.S.-based international stock ETFs saying "If those underlying stocks in Asia and Europe were still open, where would they be trading?"
Joel Dickson: I think one other thing, and this often comes up in the context of fixed income ETFs where a lot of times you'll see some slight differences between market price and net asset value, bigger than what you see in the U.S. equity market. Oftentimes, that actually reflects the transaction costs that are embedded within those types of securities.
So, you go and buy an underlying basket of bonds, which is effectively what a market-maker is going to price into what they would charge because if they get enough demand, they have to go buy new shares or create new shares with the ETF, so they're going to have to deliver a basket of bonds. Well it costs something to build that basket of bonds, and that often gets reflected in the difference, and since ETF investors are bearing their own transaction costs, a lot of times the premium, or sometimes the discount, is reflecting the transaction costs in those underlying securities, so it's actually in many ways a fair price. Even though it looks like it may be different than the value of the securities, it's a fair price once you think about the transaction costs that are involved.
Amy Chain: That's good. That sounds like an ETF 201-type question. We started with the basics, we built up from there, and unfortunately we're out of time for today. Do you have any closing thoughts to share before we wrap up?
Jim Rowley: No, I think we go back to maybe some of the basics. We see the headline banners about what's great about ETFs, and we've said, "Let's pause for a second, and if you deleted the letters ETF, and I replace it with indexing, would that phrase still apply, and the benefits that go with indexing like broad diversification, low cost, tax efficiency?"
Joel Dickson: If you are thinking about using ETFs and you haven't before, it is important to understand how do you purchase, how do you trade the ETF in a very effective way because investors that may be new to ETFs, that is something that may be new to them that can make a big difference in terms of their outcomes.
Amy Chain: That's great and for more information, there's lots available on vanguard.com, so from all of us here at Vanguard to all of you at home, we want to say thank you for joining us today. In a few weeks, we'll send you an e-mail with a link to highlights from today's webcast, along with a transcript, and if we could have just a few more minutes of your time, we'd love to hear your feedback. Take some time to respond to a survey that's going to be appearing on your screen shortly. So, from all of us at Vanguard to all of you at home, thank you and we'll see you next time.
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