Best flavor in exchange-traded funds is vanilla
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 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.
• Scott Burns is a principal of the Plano, Texas-based investment firm AssetBuilder Inc. The opinions of this article do not necessarily reflect the views of AssetBuilder Inc. This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, product or service. Questions about personal finance and investments may be sent by email to scott@scottburns.com.
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