4 Reasons ETFs are Gaining on Mutual Funds
Ron DeLegge, Editor
April 16, 2009

SAN DIEGO (ETFguide.com) – How many times have you heard or read it? Exchange-traded funds (ETFs) are overtaking traditional mutual funds in both popularity and asset growth. Yes this is true among individual investors, but it’s also true among financial professionals.

According to a just released research report from Financial Research Corp. (FRC), an amazing 71% of financial professionals used ETFs in 2008, up from just 25% in 2003.

Let’s examine a few key reasons why ETFs are gaining ground on traditional mutual funds.

100% Financial Transparency
Even though the Securities and Exchange Commission (SEC) has the noble goal of forcing Wall Street to provide investors with full disclosure, it often misses the mark. For example, a lack of financial transparency contributed in part to the financial meltdown in certain securities, like credit default swaps along with unregistered hedge funds. Even today, it’s difficult to assess the true level of risk taken by market participants if nobody knows who owns what.

What about mutual funds? Funds disclose their portfolio holdings during the first and third quarter using form N-Q and during the second and fourth quarter via the semi-annual and annual report. All holding disclosures are reported with a 60-day lag. Regarding mutual fund holdings, the Schwab Center for Financial Research states, “Frequently, you may not know which securities you're exposed to in the fund or what changes a manager has made until you get the semiannual report.”

By contrast, with index ETFs there is always 100% transparency about what securities the funds own and holdings can be viewed daily at provider Websites.

Intraday Liquidity
Critics of ETFs have tried to demonize their intraday liquidity feature. One argument is that ETFs encourage investors to become day traders. If that’s true, what can be said of other exchange-traded securities like stocks and closed-end mutual funds? Shall we take the massive trading volume of Microsoft (NasdaqGS: MSFT) or Exxon Mobil (NYSE: XOM) and mis-conclude that all of the buyers and sellers are short term traders?

Morningstar recently launched a helpful tool that illustrates the cost of ETF bid/ask spreads in percentage terms. However helpful this new tool is, it’s wrong to conclude the cost of bid/ask spreads is exclusive to ETFs.

Other exchange-listed securities, like stocks and closed-end funds have a bid/ask spread cost attached to them too. Also, mutual funds that own stocks are impacted by this subtle cost – a real cost not reflected in a fund’s expense ratio. Wouldn’t it be neat if Morningstar could start publishing the full spectrum of mutual fund costs by including bid/ask spread data for the underlying securities on all the mutual funds in its database? It’s already done this for ETFs. Why not stocks and mutual funds?

No Short-term Redemption Fees
Ever since the 2003-04 mutual fund scandals that involved late day trading in fund shares and insider market timing, the usage of back-end redemption fees has become widespread. While the main objective of redemption fees is to prevent the rapid fire trading of mutual fund shares, they’ve created other unintended problems.

For example, some mutual fund investors are being penalized for selling their mutual fund shares when they rebalance their portfolios quarterly. Even though they’re the furthest thing from being day traders, they’re being treated the same. In other words, fund investors in some cases are being penalized for doing the right thing! This is a rarely discussed problem that acutely impacts the $3 trillion dollar 401(k) marketplace. 

For equity fund investors, redemption fees are everywhere.

For example, the Fidelity Select Gold (Nasdaq: FSAGX), which invests in gold equities, has a 30-day short term redemption fee of 0.75%. The Market Vectors Gold Miners ETF (NYSEArca: GDX) has no back-end redemption fee and it charges a lower annual expense ratio. Most of Fidelity’s select industry sector funds charge the same back-end redemption fee as the Select Gold fund or a variation of this.

International funds, like the Fidelity Southeast Asia (Nasdaq: FSEAX) and the Fidelity Emerging Markets Fund (Nasdaq: FEMKX) have 90-day redemption fees of 1.50%. The Vanguard Pacific ETF (NYSEArca: VPL) and the Vanguard Emerging Markets ETF (NYSEArca: VWO), which use similar investment strategies, have no redemption fees. 

Greater Financial Flexibility
The fact that ETFs are bought and sold like stocks means greater financial flexibility for all investors. For example, stop orders are designed as an automatic trigger for an order entry or exit once a certain price level has been achieved. ETF stop orders can protect ETF investors by limiting their downside market losses. With mutual funds, it’s impossible to know the exact price or net asset value (NAV) of the fund shares you’re buying or selling. Who likes to buy products and services at to-be-announced (TBA) prices? Raise your hand.

Underlying call/put options are another tool ETF investors have that mutual fund investors lack.

One commonly used options strategy is to purchase protective put options. This allows an ETF investor to protect their long ETF positions and to offset any potential market declines. In the March and April editions of our ETF Profit Strategy Newsletter, we highlighted four key ETF options strategies. We explained the basics of how call/put options work and gave specific examples of ETF option strategies executed.

Conclusion
The financial flexibility of ETFs is one of their greatest strengths. It’s also one of the reasons more and more investors are turning to ETF investing to reach their investment goals.