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Ahead of the tape,
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Question: Martin, tell us why ETFs and mutual funds exist. In other words, what purpose do they serve in the market?
Martin Hutchinson: Both ETFs and mutual funds are ways of buying a stake in a mixed collection of shares. Instead of buying each of the shares individually, you buy a package of them.
Mutual funds came first — in 1924. They trade daily. At the end of each day, the manager works out the value of the portfolio, adds up all the values of each of the shares and divides by the number of mutual fund shares outstanding. This works out the price of which purchases and sales are made. There’s no bid and offer spread. It’s just a single price.
Then, typically, with a mutual fund, an expert fund manager selects the shares of the fund. That’s active management. But since 1976, there have also been passive mutual funds that buy, for example, the S&P 500 index.
Mutual funds have management fees, and they also have sales commissions, because they’re sold through brokers. You should try to buy low-load funds without sales commissions. Passive mutual funds have lower management fees than active ones.
Now, when you look at them compared with ETFs, they have a tax disadvantage. Even if you don’t buy and sell the mutual fund shares, the IRS, eccentric operation that it is, taxes you on the funds gains. And then you pay tax based on your own sales of the fund shares. It gets bloody complicated and expensive. So my advice, if you’re buying mutual funds, is to buy them in a tax-free IRA, which then gets rid of all that nonsense.
Question: OK, Hutch. Before we move on to ETFs, am I sensing perhaps a bearish view of mutual funds from you? Would you recommend someone buy a basket of stocks through a mutual fund?
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Martin Hutchinson: I’m slightly more bullish on mutual funds than I am on ETFs. And I’ll explain why when we’ve done ETFs.
I think that mutual funds avoid one or two of the risks of ETFs. But there’s no question that if you’re buying in a taxable account, mutual funds are a bloody nuisance.
Question: Okay, cool. I don’t like how it’s difficult to move in and out of mutual funds, and the ease upon which it is to move in and out of ETFs. Let’s jump into ETFs. Maybe you can overcome that obstacle for me.
Can you talk about ETFs and then why you favor mutual funds?
Martin Hutchinson: ETFs were invented through a series of stages between 1989–93. They’re also a pool of shares, but an ETF is traded on the stock exchange. You buy and sell the ETF like stocks. ETFs trade all the time while the exchange is open, and the price varies minute by minute, so you’ve got more than one settlement per day unlike a mutual fund.
You buy and sell them like shares. You pay a bid-offer spread, and you pay a brokerage commission. The manager of the pool collects an annual fee from the pool. And the pool can therefore shrink.
You notice this in gold ETFs, which tend to underperform gold. If gold is selling at $1,250 an ounce, a gold ETF will be rather less.
The key to the ETF is that the price is kept close to the value of the pool by arbitragers who buy and sell as the price fluctuates. Now, the arbitragers have to know what shares are in the pool in order to be able to arbitrage. (Because the way the arbitrage is, they buy the ETFs and sell the shares — or the other way around.)
So actively managed ETFs with an expert picking the shares don’t do too well. ETFs normally buy an index — and if that index is illiquid, the arbitrage doesn’t work too well. They also sometimes leverage themselves through futures. You can buy two times, three times and I’ve even seen a couple of four times leverage and inverse leverage S&P 500 funds.
The problem with that is the futures position is adjusted only daily. So you get a tracking error. That makes them worth less than they should be arithmetically. They tend to turn into the incredible shrinking fund.
I owned a bearish fund on the Chinese stock market in ’07 and ’08. The Chinese stock market dropped nicely, which should’ve made me rich, but the bearish fund dropped as well. So a fat lot of good that was.
ETF management fees are normally like passive mutual funds with no loads and lower operating expenses. Large-cap stock mutual funds average 1.3% annually in management fees, whereas large-cap stock ETFs average 0.5% annually. Over 20 years, that difference adds up.
The one blessing about ETFs is that since they’re just stocks, there are no complicated double tax calculations.
Question: I’ve got to tell you, you got me there, Hutch. I would definitely favor a mutual fund even with an inability to move in and out of it through the stock market over an ETF — where the price is decaying on me and I’m not making as much as I should have.
You got me there. Mutual funds would win out in my mind on that. All right, Hutch, give us a bottom line — ETFs and mutual funds. What is our main takeaway here?
Martin Hutchinson: The bottom line is for simple indexes, buy ETFs. And also buy ETFs for emerging-market stocks, for example, which are difficult to buy directly. You can’t buy 20 stocks on the Philippine stock exchange, so you’ve got to buy the Philippine ETF.
But if you want active fund management and you’re buying in an IRA or another tax-free vehicle, then a mutual fund is better. Also, a mutual fund is slightly less risky, because the arbitrage price-setting mechanism on an ETF could go wrong. For example, ETFs on illiquid stocks are dangerous for that reason, because the thing could blow up on you.
Question: Thanks for your time today, Hutch.
Martin Hutchinson: Great to be with you.
Question: This is Wall Street Daily signing off.
Senior Analyst, Wall Street Daily