ETFs Evolve -- For Better or Worse?
03/26/08 - 06:02 PM EDT
Knowledge @Wharton
While the average actively managed mutual fund charges investors annual fees of about 1.3% of the amount invested, the Vanguard S&P 500 fund charges just 0.18%. Spyders charge just 0.08%. If the market's annual return averaged 8% a year for 20 years, every $100 invested would grow to $459 in the Spyder, $451 in the Vanguard fund and $366 in the managed fund. The difference: fees' effect on compounding. While managed funds try to offset this disadvantage with good stock picks, many studies have shown that the average manager cannot do this consistently.
Many investors have had good results with ETFs that track broad market indexes, Allen says. "It's a good institutional form and it seems to be working very well." Mutual fund investors, their investment advisors or brokers buy and sell through a fund's parent company, such as Vanguard, Fidelity or T. Rowe Price (TROW Quote - Cramer on TROW - Stock Picks). Orders that come in during the day are filled after the stock market closes at 4 p.m., and investors buy at the share price, or net asset value
, figured by dividing the value of the fund's holdings at the market's close by the number of fund shares in circulation, or outstanding. As investors' money flows in, the fund company uses it to buy more shares of the stocks in the fund. When investors withdraw money, the fund sells holdings to free up cash for redemptions, which are paid at the end-of-day price.
ETF shares, in contrast, are created when institutional investors deposit with the fund company a basket of stock shares identical to those in the ETF. In return, the institutional investor receives a "creation unit" -- a block of shares in the ETF that are then traded like any other stock. Constant creation and redemption of these units by institutional investors assures that ETF share prices closely track the changing values of the baskets of stocks. Instead of dealing with the fund company, the ordinary investor buys and sells ETF shares through a brokerage, paying a commission as with any stock trade.
Index Funds vs. ETFs
Like all index products, ETFs are especially valuable at tax time.
Mutual funds are required by federal law to make annual payments to shareholders representing the net profits realized on stocks or other assets sold by the fund during the year, and these distributions are taxed in the year they are received. Many managed funds pay big distributions on profits realized as they constantly buy and sell in pursuit of hot investments, thus triggering big annual tax bills.
Index funds, because they hold assets for the long term, do not generate such big distributions. They do, however, realize profits and produce taxable distributions if they have to sell holdings to raise money for customer redemptions. ETFs don't do this because there are no customer redemptions: Investors who want out simply sell to other investors. Profits from gains in an ETF's holdings are reflected in the ETF share price and are taxed only after the investor sells the shares.
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