The Anomalies and Advantages of Exchange-Traded FundsSheaff Briefs Editor
Exchange-Traded Funds (ETFs), often described as “baskets” of marketable securities, contain anywhere from 30 or 40 stocks to thousands, with the typical ETF containing companies numbering in the hundreds.
Asked to compare owning ETFs to owning individual stocks, Sheaff Brock joint venture partner Mark Salzinger sees the “baskets” as a risk-reduction strategy, because with ETFs, investors are exposed to a broad range of companies. In fact, through ETFs, investors can gain exposure to “satellite” or niche positions, Salzinger adds—anything from small healthcare stocks to companies in the country of Malaysia. ETFs, therefore, may offer a big opportunity, he says, to identify and profit from market niches.
In contrast with mutual funds, Salzinger explains, ETFs have the advantage of liquidity. Like individual stocks, ETF shares may be bought and sold throughout the trading day, and, unlike mutual funds, have no redemption fees or minimum holding periods. Mutual fund shares may be redeemed only once a day; ETFs may be sold any time markets are open. Compared to mutual funds, ETFs can have much lower expense ratios; they can be more tax-efficient than most funds, especially actively managed ones. Mutual fund shareholders might incur tax liabilities even if they have not sold shares, whereas investors in ETFs have almost complete control over their own investment taxes. Also, while investors in funds face minimum initial investments, investors in ETFs can dip their toes in the water with small initial investments. That’s because there are no minimum purchases of ETF shares.
“ETFs are where the action is,” Salzinger asserts, explaining that while very few new mutual funds are being created, new ETFs are coming to market all the time. ETFs are also where the anomalies are, he concedes, because if a certain ETF doesn’t have large trading volumes, it won’t have very good pricing. An investor’s market order might well hit an “air pocket,” while an unfilled “limit order” might miss a big price move.
“Niche ETFs pose single-stock risk,” cautions Barron’s, explaining that “narrowly focused exchange-traded funds can go down like potent margaritas: great fun initially, with a high likelihood of some hurt to come.” An important metric for selecting ETFs is the Herfindahl-Hirschman index, Barron’s explains, which gauges the number of small positions in an ETF, with a higher score meaning that just a few big stocks dominate the “basket.” Having analyzed mutual funds and other investments since the late 1980s, Salzinger is all too aware of these potential dangers, and often mitigates risk by combining ETFs with mutual fund holdings in a single portfolio.
“I’m very much a real person, not a ‘robo,’” Salzinger says. Not only must he be aware of the anomalies and advantages of any given investment, the wealth manager explains, but “I need to be sold on how appropriate a match there is between any particular investment and any particular investor.”