Timing cost of index funds vs ETFs

[NormR]

What's Wrong With ETFs? They encourage frequent trading, which helps Wall Street more than investors, says the father of the index fund.

Let's say you're an index investor who wants a large stake in the S&P500. Is there a good reason to opt for a more expensive S&P500 index fund as opposed to a less expensive S&P500 ETF? (Where the comparison includes commissions and fees.)

In other words, what do folks think about Boogle's argument for index funds over ETFs when it comes to more regular index-oriented investors?

Is there a small danger that tick-by-tick liquidity, as opposed to daily liquidity, will inspire more trading? If so, is it possible to assign the problem a cost (much like the timing drag for funds)? I would guess that such a cost would be small if it exists, but with index funds and ETFs a few basis points matter.

If there is a cost, why not restrict liquidity further. Say allowing annual or monthly trades only?

Perhaps it's all just index fund FUD?

[Norbert Schlenker]

It's possible to abuse just about anything. In many cases, not doing so is a matter of self discipline. This is no different.

If you're a long term indexer, then you buy the cheapest product, which in many cases nowadays is the ETF. If one of the features of the product is that it allows you to abuse your investment philosophy by trading, there is nothing that says you must.

Is Bogle right? For many people, maybe. The gambling instinct is powerful and very common. But no one makes you gamble (and no, Norm, I doubt we can quantify the cost of the temptation of gambling on the average "indexer").

[NormR]

Is Bogle right? For many people, maybe. The gambling instinct is powerful and very common. But no one makes you gamble (and no, Norm, I doubt we can quantify the cost of the temptation of gambling on the average "indexer").

Perhaps a different angle, would you recommend the ETF over the index fund to a client if the ETF was 5bp, 10bp, etc less expensive?

[AltaRed]

Perhaps a different angle, would you recommend the ETF over the index fund to a client if the ETF was 5bp, 10bp, etc less expensive?

As a 'buy and hold' investor, I would certainly choose the ETF....and I do in my own portfolio.

[sevimo]

ETF INVESTING: ETF Managers Courting Hedge Funds, Financial Advisers

With traditional mutual funds, hair-trigger traders can cause trouble because the portfolio manager has to buy and sell stocks in order to invest or raise cash. This activity increases transaction costs and taxes for longer-term investors. Many fund families charge redemption fees specifically to discourage such rapid trading.

However, one reason ETFs can charge lower fees is that investors don't interact directly with the fund since shares are traded on an exchange. This allows the manager to focus on running the portfolio and cuts down on administrative duties.
...
Put simply, traders and long-term investors usually don't step on each others' toes in ETFs as they often do in mutual funds.

"Different constituents use ETFs for very different reasons," said Tony Rochte, senior managing director at Boston-based ETF giant State Street Global Advisors. "Whether active traders or buy-and-hold investors, they won't have a negative impact on other investors."

You can always shoot yourself in the foot if you want to; frankly, I don't care much if it doesn't affect me. In mutual funds, active trading will affect me, thus all the restrictions/redemption fees. In ETFs, it doesn't worry me at all if it "encourages" day-trading. It doesn't force me to do so, and I am not affected by all the other day traders. The important things is still there - ETFs are cheaper, even if by 5 or 10 bps - why would I want to give away even that much for nothing?

And it definitely doesn't make sense to me to limit liquidity (especially to annual trades!). This will limit my rights as they are now; and what will I get in return? So that someone else is not "encouraged" to do active trading, which probably will increase his/her returns? What's in it for me?

As they say, "don't blame the tool"...

[Antoni]

It seems to me the question has to be considered not only as to the product in itself (which one has the lower MER), but also as to the investor needs (one-time investment or smaller regular investment, an investment to hold for many years or an investment on which there will be regular withdrawals in a not too far future).

All will agree that with small regular investments, ETFs are seldom appropriate (as the cost of the transaction would be too high in proportion to the investment). At the other extreme, in the case of a large investment for many, many years, ETFs would probably be more appropriate than mutual funds. I'm not aware that we have in Canada such things as the Vanguard Admiral Shares, geared to long-term large investments, which would make mutual funds more competitive with ETFs by lowering the MER.

In between these two extremes, it's a matter of balance of the various factors taking into consideration each particular situation. For example, I wonder if many ETF investors don't forget to take into consideration that there may come a time when they will need to withdraw some money. The transaction costs on withdrawals may then absorb a large part of the savings made in the previous years by reason of the lower MER.

[sevimo]

Well, indeed ETFs can be more expensive than mutual funds; that's not the issue here. If buy-and-hold people will see that index MFs are cheaper for them, they'll use MFs.

But the issue that is discussed here is advantages/disadvantages of ETFs due to their capability to be actively traded. I see it as a pure advantage for the product, as you can day trade and short it if you want, but you don't have to. And it doesn't affect other investors.

[Norbert Schlenker]

Perhaps a different angle, would you recommend the ETF over the index fund to a client if the ETF was 5bp, 10bp, etc less expensive?

I would.

In the end, locking the client into the portfolio is a behavioural issue. My obligation as an advisor is to get the client to control his/her behaviour.

It's a short drive from using the more expensive index fund because it imposes discipline against trading to using a DSC fund because it imposes even more discipline against trading. I will not recommend a more expensive solution on the theory that my client is an idiot who must be penalized extra to prevent him/her from acting like an idiot.

It's my job to prevent idiot behaviour. I get paid for it. Why should the client pay on top of that to restrict access to a potentially valuable option?

[pitz]

In between these two extremes, it's a matter of balance of the various factors taking into consideration each particular situation. For example, I wonder if many ETF investors don't forget to take into consideration that there may come a time when they will need to withdraw some money. The transaction costs on withdrawals may then absorb a large part of the savings made in the previous years by reason of the lower MER.

A major US-based brokerage firm already offers $1 trades. $4.95 RRSP trades are available from yet another broker. Transaction costs are similar to the cost of a postage stamp. Is that really an impediment to using ETFs versus index funds with 'free' transactions?

Behaviourally, for me, the approach I use is to mark my tax liabilities to market, as well as the prices of my funds on the same spreadsheet. I think the financial advisory community could make good use of this concept as well, especially on account statements, to re-inforce the liability that is incurred if a fund is sold/traded. As the calculus of RRSPs have taught us, there is a very strong urge amongst investors to avoid and/or minimize taxes, sometimes even to the point where people dramatically overcontribute to RRSPs merely for 'the tax break'. This urge can, and should be harnessed by a professional advisor as one of the tools to keep a client 'on course' with indexing, during its ups and downs.

As indexxing frees an advisor from much of the research associated with securities selection or mutual fund manager selection (well I guess many smart managers outsource that firms like DanH's already....), the professional advisor can and should be providing more tax education to clients, which ultimately should improve their investing outcomes.

[Bylo Selhi]

Vanguard has a nifty calculator to compare costs for Vanguard ETFs and mutual funds. Granted, it only compares Vanguard ETFs to their own open-end funds that aren't available to Canadians, however, you can use this as a starting point to do your own comparisons with Canadian index funds like those from TD or CIBC.

The calculator is useful for several reasons:
1. It incorporates brokerage fees and spreads, as well as MERs, in its analysis.
2. It compares cost savings on both a single lump-sum investment as well as on regular monthly, quarterly or annual investments.
3. It gives you detailed cost and value comparisons so that you can see how they arrived at their numbers and how you can tailor their analysis for Canadian MERs.

I'm waiting for the other ETF sponsors to come up with a similar, but better tool to prove that they give more from their higher MERs. (I'm not holding my breath waiting.)

[marty123]

In between these two extremes, it's a matter of balance of the various factors taking into consideration each particular situation. For example, I wonder if many ETF investors don't forget to take into consideration that there may come a time when they will need to withdraw some money. The transaction costs on withdrawals may then absorb a large part of the savings made in the previous years by reason of the lower MER.

A major US-based brokerage firm already offers $1 trades. $4.95 RRSP trades are available from yet another broker. Transaction costs are similar to the cost of a postage stamp. Is that really an impediment to using ETFs versus index funds with 'free' transactions?

And if these sums are still too high, nothing prevents a retiree from reversing the MF-to-ETF flow he used to cheaply DCA into a long-term held ETF by moving big chunks (1 or 2 years worth) of ETFs back into an indexed fund with the expectation of gradually selling a few units each month starting 90+ days from now (assuming he has the guts to cash equities directly instead of transitioning to MMs, bonds or GICs first).

If this need arises during the accumulation phase, for rebalancing or re-allocation, then the investor likely didn't have a long-term plan or is a bit quick on the trigger. Even in an RRSP charging $10 or $20/trade (yes, I know that some people pay $30, but why?), the payback of an ETF (vs MF) can be in a matter of weeks or months.

[mikester]

I don't see what the difference is between index funds and etfs in terms of trading. You can lose (or gain) just as much doing 3 trades a year in an index funds as you can doing 3 trades a week (or hour) with an EFT.