The “benefit rich” investment, Part 2

How ETFs work

We’re going to walk a tightrope today as the conversation will be both mildly technical and somewhat over simplified. But the differences between a mutual fund and an indexed ETF are dramatic, and should be understood. Lower fees and costs – universally acknowledged as the single most controllable variable in determining investment returns – are the most commonly discussed benefits of using ETFs. But as the number of ETFs grow (remember, 1300 are pending approval), how an ETF is structured, and the kind of assets it contains, mean many are starting to not look much better than a mutual fund.

So, let’s look at a completely different kind of investment, commodities futures, as a way to explain how an ETF works. For our example, let’s assume you’ve decided to purchase a big slug of corn, betting on a drought to make the bushels more valuable when they are finally sold to a food producer to make Corn Flakes. A commodities broker will take your $10,000 and give you a receipt, with the corn in discussion stored in a couple of big silos in Iowa, as collateral.

Now, if in 90-days when the corn is sold it is worth more than you paid, you will redeem your receipt and earn a profit. If your bet on a drought was wrong, then you cash in your receipt for less than you paid and take a loss on the investment. But at no time does a truck show up at your house and dump $10,000 worth of corn in the backyard. The point here is that you never actually take possession of the corn. You simply trade – buy or sell at anytime during the duration of the contract – the rights to $10K worth of corn.

And herein lies the fundamental difference between mutual funds and exchange-traded funds. While the sponsor of an ETF – folks like BlackRock or Vanguard – have to own the actual stocks and bonds, you never take ownership of the underlying assets. Instead, you own the rights to a specific dollar amount of the pool of assets in the fund. You can buy in the morning and sell the same afternoon (not recommended). It is even possible to trade baskets of foreign assets when European or Chinese markets are closed. ETFs can be owned for hours or years.

A traditional mutual fund purchases (simplified for this example) a basket of equities they believe will out-perform the overall market. The reason shares of the mutual fund can only be bought or sold once each day, after the stock markets are closed, is because the fund has to balance the money coming in (people buying shares) and the money going out (people selling their shares) to ensure the amount of stocks they own equals the amount of money they have invested.

This need for balance then impacts all other investors in the mutual fund and can causes losses in the value of the fund, or create a tax liability even if you have done nothing. If a mutual fund uses leverage (borrowed money) a big redemption (sale of shares) can force the fund manager to force a sale that can impact the other shareholders. This means you can be hurt by the actions of other investors in the mutual fund.

Instead, like the example of corn futures above, while a sponsor such as BlackRock or Vanguard does take physical ownership of the stocks that underlay the ETF, you don’t. You can buy and sell your rights to the assets in the ETF, but you don’t ever take possession of the stocks. This also means the burden of taxes falls on the sponsor, not the investor.

If an entity like a pension fund wants to buy $100,000,000 worth of Vanguard’s S&P 500 ETF (VOO), Vanguard then purchases a hundred million dollars worth of the stocks that make up the S&P 500 index and issues shares. When the pension fund decides to sell VOO, Vanguard can liquidate what’s needed for redemption without impacting other investors.

As more investors, large and small, discover the many advantages of using ETFs their use will grow. Yet with less than 9% of all investable stocks and bonds currently inside of ETFs, it will likely be a long time before they become “too big to fail” as has been recently suggested.

Next up, “So, what do I buy?”

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