Q. My wife and I are both retired. I am a fan of your Couch Potato portfolio and have tried to allocate our retirement funds in a similar fashion, with Vanguard index stock and bond funds. In your column you often recommend investing in exchange-traded funds. Any portfolio is subject to market fluctuations, but is there additional market risk associated with an ETF as opposed to a mutual fund?
In other words, when the market goes down, will the value of an ETF decrease more than a mutual fund (assuming the underlying securities are the same)? If an investor is trying to minimize volatility, is a mutual fund preferable to an ETF? What are the advantages of an ETF? —B.H., by email
A. Exchange-traded funds can have some additional risk, but it is minimal IF you are investing in the large, highly liquid ETFs. Here’s the difference:
When you buy a mutual fund, the company that issues the fund shares commits to redeeming the funds once a day, based on closing prices for that day. So the net asset value per share of the fund is exactly what you get when you redeem (or buy) shares.
Exchange-traded funds are different because, like closed-end funds, they trade on the open market. So you redeem by selling shares, at any time you want during the day, at the market price. The market price, however, isn’t always the same as the net asset value per share. If the sell-order book is heavy, the shares will sell for less than net asset value per share because the market price will be lower. If the buy-order book for purchases is heavy, the shares will sell for more than the net asset value per share because the market price will be higher.
The size of this difference will depend on what’s happening in the market and how much volume there is in the ETF shares. If you own shares of a small and obscure ETF, for instance, you could pay a premium going in and suffer a discount going out. More likely, you’d buy and sell at a discount to net asset value. Add a terrified market and the difference between net asset value and sale price can be pretty painful. The difference is very small, however, with the large “plain vanilla” index ETFs.
The SPDR S&P 500 ETF, for instance, is a huge ETF that tracks the S&P 500. Recently, the selling premium over the net asset value was averaging 0.02 percent. According to the fund’s prospectus, in 2014 the total days at a premium were virtually equal to the total days at a discount, 124 to 125. The prospectus also notes that the market price has been within 0.25 percent of net asset value per share more than 92 percent of the time since the fund went into operation in early 1993.
You can expect similar, but not identical, statistics for other ETFs that have substantial assets and that trade in high volumes. The SPDR S&P 500 Index ETF has over $177 billion in assets and trades about 20 million shares a day.
Move to an ETF representing a smaller asset class and the premiums or discounts widen. The Vanguard FTSE Emerging Markets ETF (ticker VWO) for instance, recently was selling at a discount of 0.50 percent to net asset value per share even though it has about $50 billion in assets and is actively traded.
The brokerage bid/ask spread when buying or selling is another cost that is quite similar to the costs you can incur from premiums or discounts in net asset value. In heavily traded ETFs, the spread will be small. In smaller ETFs with less trading, the bid/ask spread will be larger.
These two factors, combined, can sometimes cost more than the expense ratio of the ETF itself. The thing to remember, always, is that the larger ETFs that represent large asset classes and are heavily traded will minimize these costs. Visit the etfchannel website and you’ll find a list of ETFs ranked by size.
With careful selection, exchange-traded funds can deliver lower costs than typical mutual funds. You can easily build a low-cost starter portfolio with SPY, the SPDR S&P 500 ETF; EFA, the iShares MSCI EAFE ETF; VTI, the Vanguard Total Stock Market ETF; VWO, the Vanguard FTSE Emerging Markets ETF; IWM, the iShares Russell 2000 ETF; BND, the Vanguard Total Bond Market ETF; and VNQ, the Vanguard REIT ETF.