The Costs and Benefits of Exchange-Traded Funds

Exchange-traded funds (ETFs) have exploded in assets both in Europe and across the globe, and their complexity seems to be increasing just as quickly. As we continue our effort to serve investors of all stripes with an independent source for financial data and analysis, we have started a new team dedicated to researching European ETFs.

An introduction to ETFs
Exchange-traded funds are a fairly new investment vehicle, and can best be described as a fund that trades on stock market exchanges. The first ETFs in the US and Europe were passive funds that followed broad stock indices, allowing investors to track the performance of major equity markets through a single low-cost fund. The next ETFs to strike success bought actual bars of gold, allowing individuals to own this classic diversifier for a very low cost compared to paying retail bullion prices and paying for a safe deposit box or other security measure. Since then, new ETF offerings have blossomed to embrace nearly every aspect of the capital markets. Today it is possible to buy an exchange-traded fund that tracks anything from the European corporate bond market to emerging market small companies to lean pork belly futures contracts.

The potential benefits...
The single biggest boon of this new fund type lies in its incredibly low costs. ETFs tend to follow passive stock market indices, so they do not need to worry about the cost of high-salary analysts working away to pick companies for investment. But this explains only half the cost savings of ETFs. While traditional funds management companies need extensive back-office systems to track purchases or sales throughout the day and track the share balances for their thousands of investors, ETF managers only need to worry about transactions with a small handful of market makers who buy and sell the extra shares on the exchange. This greatly simplifies the management and trading operations of ETFs, and allows individuals to buy these funds at management costs previously only accessible to large institutions such as pension funds or insurance companies.

The next biggest benefit of ETFs has been the opening of new asset classes. Sure, some fund managers would buy into emerging market bonds when they looked cheap, but how could an individual do the same? Or how about currency investment using a carry trade strategy without pouring time into managing a forex account? Now these asset classes and strategies are available in ETFs trading on multiple exchanges across Europe. And unlike actively-managed funds, ETFs stick to a single strategy or defined portfolio, so you know that what you buy today will be what you hold tomorrow.

The ability to buy all these new asset classes certainly does not mean you should. In fact, many of them tend to be poorer investments over the long run than good old bonds and common stocks. Still, in the hands of a savvy investor, these new asset classes open up a range of new strategies that have their time and place to supplement a balanced traditional portfolio.

The fact that ETFs trade throughout the day on stock market exchanges adds a couple of other differences for those used to funds. Purchases and sales can happen almost immediately, so that investors know precisely what price they pay for the fund shares rather than waiting until the end of the day. This also means that trading in and out of ETFs is not free; investors pay a commission to buy or sell, though it will be the cost of a stock trade and will go to their broker rather than their adviser or the fund company.

Closed-end funds have offered intraday trading for decades, but were also notorious for the premiums and discounts they could trade at relative to the value of their underlying holdings. ETFs avoid this issue through their constant ability to issue new shares or redeem unwanted shares from the market. If the ETF trading price dips too far below the value of its holdings because investors are selling it, then any number of specialty trading firms will happily buy those cheap ETF shares and sell the fund’s basket of underlying holdings until the discount disappears. The trading firm can then square its books by giving the unwanted shares to the ETF manager, who returns the equivalent basket of holdings from the ETF portfolio in an “in-kind redemption”. The same process in reverse will cause any premiums to disappear as trading firms sell ETF shares on to the market while buying up the underlying holdings, and creating new shares of the fund at the end of the day. It’s a nice way to get arbitrage firms working for the benefit of small investors, who are able to trade larger ETFs without fear of paying a premium or selling at a steep discount.

...And the potential costs
Of course, like all financial innovations, exchange-traded funds are not all roses for the common investor. I already mentioned that all these brand new investment options in currencies, commodities, and all the rest can be as much of a trap as a boon. ETF portfolios can also court some risk of a major financial calamity leaving them high and dry, whether due to securities lending or reliance on swaps to provide returns. Finally, the costs of trading ETFs should never be ignored, and in some situations can even make them more expensive than traditional fund alternatives.

The bottom line
We at Morningstar think that these new funds provide a powerful tool for individual investors to finally match big institutions, both in the breadth of available asset classes and the lowest possible management costs. The new European ETF Research team can not wait to provide the information and guidance you need to begin using ETFs responsibly and profitably. Later this week, my colleague Ben Johnson will write about the state of the European ETF market at the beginning of 2010. In the coming months, we will keep bringing you news of the ETF market, any interesting opportunities we see, advanced coverage of the unique twists and pitfalls of this new fund type, and general advice for investing your stable long-term portfolio as well as your interesting side bets. We will also bring in new tools to help you sort through the bewildering array of new funds to find precisely the ones you are looking for. We hope you will keep checking in with us as things develop.