This past Wednesday, I participated in ETF Master Class – Boston, sponsored by our friends at Bloomberg and Wolverine Execution Services (WEX). I have participated in a few of these in the past and I would highly recommend them for anyone looking to learn more about the ETF space.
In my opinion, what sets these events apart is their practicality. I find that many similar events are a bit too theoretical in nature, while the ETF Master Classes tend to delve into more actionable topics for practitioners – including specific details around how to conduct ETF research, how to use ETFs to achieve specific portfolio objectives, how to trade ETFs, and important current and future trends within the space.
My panel covered a lot of ground in a short period of time. We touched on currency hedged ETFs, interest rate hedged ETFs, validity of tracking error as a measurement of ETF performance, the mortal sin that are market orders in ETF – or any other – trading, the meaninglessness of average daily volume when measuring ETF liquidity, among others.
However, what really seemed to get the audience engaged was a discussion of a recent editorial in the Financial Times in which John Bogle expressed strong doubts about the long-term value of ETFs to investors. Bogle wrote:
“Mark me as a member of the small group of cohorts who are dubious about the utility of ETFs for long-term investors. Yes, broad-market exchange traded funds are fine, as long as investors do not trade them.
I freely concede that the ETF is the greatest marketing innovation of the 21st century. But is the ETF a great innovation that serves investors? I strongly doubt it. In my experience – almost 64 years in the industry – I have learnt to beware of investment “products”, especially when they are “new” and even more when they are “hot”.
Avoiding hot new products is unlikely to impair the returns that investors earn. Far more likely the reverse is true.”
Setting aside the irony that Mr. Bogle is most famous for pioneering a new investment “product” - the first index mutual fund available to the general public – the argument that he lays out is flawed and many industry heavyweights haven’t held back in saying so.
What I find most interesting is that almost all of the dialogue has focused on the liquidity difference between ETFs and mutual funds – intra-day vs. end of day. Liquidity is only one of the two major differences between the two product wrappers.
The other main difference is the tax advantage of ETFs that results from the create/redeem mechanism. Through careful management of creates and redeems, most ETFs are able to avoid capital gains distributions. Even index mutual funds – generally considered the ultimate tool for tax efficiency – will be forced to realize gains as index constituents change over time.
This tax advantage can be larger than what many may expect. I decided to pick a random index fund to illustrate the point and settled on the Fidelity Spartan® Small Cap Index Fund (ticker: FSSVX). FSSVX paid four capital gains distributions since the beginning of 2013. These distributions totaled $0.909 (for reference, the 3/31/15 NAV of the fund was $17.52). $0.571 – or roughly 63% - of these distributions constituted capital gains.
Using the tax assumptions below, we can estimate that the total after-tax return for a shareholder from 12/31/12 to 3/31/15 would have been somewhere between 50.09% and 51.11%, depending on how much of the capital gains distributions were short vs. long term. An ETF running the strategy would have returned approximately 51.87% since distributions – and therefore the associated taxes – were much lower.
So in this example, the tax advantage of the ETF for a buy and hold investor lies somewhere between 76 and 178 basis points over the nine quarters we considered. While this might not sound huge, it does represent a total cost increase of between 1.7x and 4.0x relative to the 45 bps of expenses paid for being in the fund over the same time period.
This hardly seems “dubious for long term investors.” In fact, many investors in Vanguard’s index mutual funds now are able to leverage the tax efficiency of ETFs. How? Vanguard has a patented share class structure in which their ETFs are simply another share class of the related mutual fund. As a result, the ETF create/redeems can be used to manage index constituent changes for the entire portfolio, benefitting all investors regardless of whether the strategy is held via an ETF or fund.
Tax assumptions: 15% on qualified dividends, 15% on long-term capital gains, 35% on short-term capital gains.