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The Pros and Cons of ETFs

Part II of our guide to ETFs

Christopher J. Traulsen, CFA 12 January, 2007 | 6:53PM

In Part I of this ETF guide, we walked through the basics of how exchange-traded funds (ETFs) work. Here, we'll take a closer look at ETFs, their advantages and disadvantages, and give you the information you need to decide if they might be a good fit for your portfolio.

Trading Flexibility
One key advantage that ETFs have over traditional mutual funds is trading flexibility. ETFs trade throughout the day, so you can buy and sell them when you want. However, it’s worth noting that the arbitrage mechanism (for more on this, see Part I of this guide) that keeps the prices ETFs trade at in line with their NAV, although very good, is not fail-safe. One premium discount study run by Salomon Smith Barney a few years back found that most were very small, and this can be seen in the general ability of the market return of ETFs to track their respective benchmarks’ well. However, there have been at least one instance of a sharp discount opening up. In 1998, iShares Malaysia traded at a 30% discount to NAV when Malaysia instituted capital controls.

It’s also noteworthy that some ETFs trade during periods when the market they track is closed (Japan ETFs, or example), which will cause their market price to deviate from NAV. The pricing appears to be much like that of futures, with investors bidding the market price up or down based on their expectations of the next day’s market movements. On the whole, however, the premiums/discounts on ETFs are extremely small when compared with those of Investment Trusts (closed-end funds).

In terms of the annual expenses charged to investors, ETFs are considerably less expensive than the vast majority of OEICs and unit trusts. iShares FTSE 250, for example, has a TER of just 0.40% per year, whilst HSBC FTSE 250 charges 0.77%. That kind of difference can add up to a large performance edge over time.

Still, the expense advantage of ETFs may prove to be more mirage than fact for some investors. That's because you must pay commissions to buy and sell ETFs, just as you would for stock transactions. If you plan on making a single, lump-sum investment, then it will almost certainly pay to choose a cheaper ETF over a traditional tracker. However, for those who plan to make regular, relatively frequent investments, if you have access to a fund that does not carry sales charges, that will often be cheaper than buying the ETF and paying commissions. We will soon implement a cost analysis tool on to help investors decide which route will save them the most money, so do check back.

Currently, only those ETFs tracking UK equity or bond indices are denominated in sterling. Many ETFs that trade on the LSE are denominated in US Dollars and Euros (generally, those tracking European indexes are denominated in Euros, while those tracking indexes in other regions are denominated in dollars). If the fund’s investments are in a different currency than it is denominated in (e.g., if its base currency is USD and its portfolio exposure is to the yen), this imposes an additional element of currency risk that investors need to keep in mind.

Because they are shielded from investor trading (remember, investors trade among themselves over an exchange—only those dealing in 50,000 share blocks called creation units deal directly with the fund), ETFs shouldn't have to keep cash on hand to meet redemptions, or be forced to sell stocks into a declining market for the same purpose. In all, this should allow ETF managers to run their portfolios extremely efficiently, which could give them a slight edge over traditional trackers.

ETFs have a lot to offer. They're flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading, making them more efficient to manage than traditional OEICs and unit trusts.

Nevertheless, look carefully before you leap. ETFs' cost advantage isn't always as large as it might seem, and trading costs can quickly add up. Particularly if you wish to invest regular sums of money, you may be better off choosing a traditional fund without sales charges. If you’re investing a lump sum, however, or if you can’t access a fund without paying an initial or deferred charge, ETFs may well give you the best value for money.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Christopher J. Traulsen, CFA

Christopher J. Traulsen, CFA  is director of fund research, Europe and Asia, Morningstar.