03 Dec The Rest of the Story… EFT’s

We are all very familiar with open-ended mutual funds – the ones that have been around longer than most of us.  Their Net Asset Value (the combined value of all of the individual securities they hold) is valued at the end of each trading day, and, no matter when during that day we place our order to buy or sell shares, that is the price at which they trade.

What most of us are less familiar with, are exchange-traded funds, or ETFs.  These are very much like open-ended mutual funds in so far as they are pools of many securities and they come in all shapes and sizes.  What’s different about them is that they trade like individual stocks.  We can buy or sell them at anytime during the trading day at whatever their going price is at the moment.

This and an obscure potential tax advantage are pretty much their only advantages over open-ended mutual funds.  They carry a couple significant disadvantages, however, that are important for us to understand before we invest.  First is the hidden ‘sales charge.’  Like no-load funds, ETFs carry no published sales charge.  There is, however, a hidden sales charge called the bid-ask spread.  Because ETFs trade like stocks, specialists at the stock exchanges offer to buy them at one price (we’ll call that the wholesale price), mark them up, and then offer them for sale at a higher – we’ll call the retail – price.  This spread between the wholesale and retail price can be as much as 2% or more on lesser-traded ETFs.

So, as we all smartened up to the easily hidden front-end sales charge on open-ended mutual funds and began buying no-load funds without broker sales charges, the industry figured out a way to lure us away to mutual funds on which they could levy a different kind of hidden sales charge.

The second disadvantage that ETFs have over open-ended mutual funds is that they often trade at prices that differ from their Net Asset Value.  This is because rather than selling at the true value of their underlying assets, their market price reflects the supply and demand of the ETF itself.  This means that we can buy a basket of stocks worth a dollar, but be paying a dollar and a nickel or more on top of the spread.  Or, we could be selling that dollar’s worth of stock and receiving only ninety-five cents, less the spread.  The problem is that most of us are unaware of what both the spread and the discount or premium are at any point in time.

ETFs are great for day-traders who move in and out of the market trying to guess and take advantage of its highs and lows.  They enable them to bet on the market rather than having to bet on individual securities.  But, most of us are not day-traders.  So, we have to ask ourselves whether that benefit outweighs its cost.  And if, for whatever reason, we decide that it does, it would be to our advantage to be able to identify both the spread and the premium or discount at the moment we choose to place our trade.

And that, as Paul Harvey would say, is the rest of the story.