Are ETFs Overrated?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Exchange-traded funds have gained market share at the expense of traditional index funds, but have some of their benefits been oversold? Have some of their benefits been undersold? Joining me discuss that topic is Ben Johnson. He is director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: You wrote a great piece in Morningstar ETFInvestor, we also ran it on Morningstar.com, looking at maybe some of the underrated elements of ETFs as well as some oversold or overrated elements. One of them you say is liquidity, the ability to trade ETFs intraday. Talk about why you think that maybe kind of an oversold benefit.

Johnson: Liquidity and the ability to trade all day every day is simultaneously somewhat overrated and out of frame. It doesn't paint the whole picture of the flexibility of ETFs as an investment wrapper. Because at the end of the day, that's all they are. It's a form of packaging, a way of wrapping up and delivering an investment strategy to investors. Liquidity, I would argue, is overrated to the extent that who really needs to trade exposure to the S&P 500 all day long. If anything, there's the risk of temptation, if you will, that investors might trade more than they would have otherwise using an ETF as opposed to a mutual fund format.

Now, I would argue that there's scant evidence that this is indeed the case. The research that is out there shows that--to paraphrase Taylor Swift--traders are going to trade, irrespective of whether they are using ETFs, individual stocks, cryptocurrencies, you name it. If that proclivity is there, ETFs aren't going to make them anymore likely to trade than they had been previously. So, overrated.

Also, as I mentioned before, somewhat mischaracterized. Because ETFs are stocklike instruments, the "ET" stands for exchange-traded, there are other ancillary benefits that accrue to, especially long-term investors, in that respect too to the extent that ETFs like stocks can be sold short; owners of ETFs can lend them out and actually earn revenue for lending out ETFs as much as they might lend out other securities; ETFS often have options associated with them. What all of these other elements of sort of flexibility, these dynamic elements of the wrapper lend themselves to is a much wider investor base than you might have with a traditional mutual fund. The greater the pool of prospective investors, the greater the liquidity in the ETF, the larger that ETF will become. Thus, the overall cost of owning that ETF, in theory, will be driven ever downward because transaction costs would be lower, the greater the investor base, the greater the asset base. In theory, the lower the fees will be on that ETF. that's a huge benefit to long-term investors in those funds.

Benz: That flexibility, the ability to do a lot of different things within ETF broadens the pool and then some additional benefits come on board?

Johnson: It can begin to snowball to the benefit of long-term buy-and-hold investors.

Benz: Transparency is a benefit that you see is somewhat oversold, this ability to see an ETF's portfolio in real time. Why do you think that's not such a big deal?

Johnson: I don't know about you, Christine, but I personally have no interest in knowing what 500 stocks are in the S&P 500 all day, every day. What I take heart in is knowing that there are rules that guide the construction of that portfolio that it's fairly predictable. Transparency is oversold.

What might be undersold in this case is a term that Jack Bogle has used before, which is "relative predictability"--knowing what to expect, knowing what you are going to get. In the case of index-tracking ETFs and those tracking broadly diversified market-capitalization-weighted indexes in particular, you know exactly what you are going to get. More often than not the label on the tin is going to match its contents. That said, there are important exceptions, areas where you are going to have to dig more deeply. But even still to the extent that those are index-tracking products. There is this incremental element of relative predictability that you might have, say, over an actively managed fund.

Benz: It certainly gives you a great ability to get your arms around your exposures in your portfolio. You can see what your equity weighting is in real-time which can be important information for you as an investor.

Johnson: Incredibly important information, especially when you zoom out and move away from fund selection and toward portfolio construction to have a better sense of what's the stability of these building blocks, to what extent might there be overlap between what I would otherwise assume to be distinct strategies.

Benz: Right. Let's talk about tax efficiency. There's a lot to like from the standpoint of tax efficiency for ETFs. You think that the benefit relative to traditional market-cap-weighted index funds has been perhaps little bit oversold.

Johnson: Definitely. We've discussed this in the past, which is that, when it comes to tax efficiency, ETFs have two key sources of tax efficiency. One has to do with their strategy. A market-capitalization-weighted U.S. stock index is going to turn over 3% to 5% a year, which is a fraction of the level of turnover you'd see in your average U.S. large-cap fund. That low turnover yields large benefits in terms of tax efficiency. There's an incremental layer that isn't unique but far more commonplace in ETFs than it is in other fund types, which is structural in nature. ETFs have the ability to take securities into the portfolio and purge them from the portfolio on an in-kind basis. They are not necessarily actively-buying and selling those securities. Particularly, when it comes to redemptions from the fund, what you see is the ability to send stocks out of a stock portfolio in kind, thus avoiding unlocking embedded gains, yields a huge structural advantage that certainly is there in the case of ETFs tracking market-cap-weighted indexes, but I think is much more prominent and where the ETF structure really flexes its muscles is in the case of underlying strategies where the turnover is in excess of 100% per year. What you see is if you look at the data on strategies that fit that description, going back over the course of the past five years, is that capital gains distributions among those funds have been few and far between. I think that's really where ETFs' tax efficiency is on full display.

Benz: To the extent that you want some sort of high-turnover strategy in your portfolio, the ETF wrapper can actually shield you from some of the taxes that you might pay in a traditional open-end format?

Johnson: Absolutely. And further to that, what I would say is, it's also an additional insurance policy even in the case of funds that might be tracking a market-cap-weighted index. What we've seen in recent years is that there are a lot of cap-weighted index mutual funds that have been spitting out huge taxable gains distributions, largely because they have seen shareholder exoduses. To the extent that the structure will, again, add an incremental layer of insurance in the unlikely event that some total stock market mutual fund sees a huge shareholder exodus, the ETF has an advantage in that respect as well.

Benz: We've done a separate video on this topic--Vanguard's ETFs may be an exception to that--for some reason they did see some mass shareholder-related redemptions.

Johnson: Right. To the extent that they are unique in being a separate share class of Vanguard mutual funds.

Benz: Let's talk about fees, because of the big attractions for ETFs is the fact that on many of the big market-cap-weighted products fees are very, very low. But you say relative to the true peer group of traditional index funds, the fee advantage may be a little bit overblown.

Johnson: Fees maybe equal. The poster child for this would be the Vanguard ETF share class and the Vanguard admiral share class, where the fees charged across both for the same exposure, for access to the same fund will be at parity. The fee advantage really isn't there, and if any anything, in the case of the ETF, there are the incredible costs that might be involved in transacting in that fund. The advantage that ETFs have over index mutual funds in some cases--though I would say, as minimum investment requirements for mutual funds come down ever further and in some cases are now zero--ETFs can have an advantage in that they are more immediately accessible, that you can invest in an ETF an amount as low as a single share and get pricing that, going back to the Vanguard case, would require $10,000 minimum investment in the case of their admiral share class.

Benz: Always great to get your insights, Ben. Thank you so much for being here.

Johnson: Thanks for having me, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.