Why are ETFs Fairer than Mutual Funds for a Long Term Investor?

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Are you a long term investor, perhaps one who makes regular investments in mutual funds with no intention of taking them out in the near future? Are you the kind who holds on to your existing investments in times of panic even when it feels others around you are selling (e.g. what did you do during the market crash in Sep 2018)?

If you are one of the patient/buy-and-hold type of investor, then ETFs might be of interest to you – primarily because they are inherently fairer (and hence, cheaper) to investors like yourselves when compared to mutual funds.

As we discovered in the previous post, the creation/redemption mechanism of the ETF units by Authorised Participants (APs) is what makes ETFs such a unique & popular instrument. APs act as market-makers by taking opposite sides of the trade – thus keeping the ETF prices in-line with the underlying NAV of the fund, while simultaneously allowing the units to be traded on an exchange like a stock.

Trading Costs & Long Term Investor

APs are incentivised to do this because in exchange, they earn the spread between the NAV and the bid/ask price at which the ETF units are sold. The key benefit of this mechanism is that it offers a cost-efficient way for fund managers to manage the fund by reducing trading expenses that are normally incurred while buying/selling stocks.

Mutual funds incur trading costs in the following cases:

  1. The initial set of stocks purchased when the mutual fund scheme is being launched, i.e. during the NFO
  2. Any subsequent buying/selling of stocks due to the views of the fund manager, which can be fairly frequent
  3. Any subsequent buying/selling of stocks each time investors subscribe/redeem from the funds – which is daily

All these activities incur trading costs, which negatively impacts the returns of the fund, ultimately reflected in lower NAV & impacting all investors. Unfairly enough, even if you decide to buy-and-hold to your investment, you will still be bearing the costs incurred due to the behaviour of other investors who trade in/out of the fund (as in case #3).

The trading costs associate with ETFs however, is different as the fund itself only incurs the first 2 costs. First, when the fund is being launched & the initial set of stocks need to be purchased, and subsequently when the fund composition changes, which in the case of ETFs happens only when the index composition changes (which is every 6 months for most indices).

As such, it’s only these 2 costs that existing investors in the fund pay for. ETF investors don’t pay the costs associated when other people enter/exit the fund since this subscription/redemption” (or buying/selling) to the ETF happens in the secondary market via APs.

It is the APs who incur the initial trading costs, which is then ultimately reflected in the bid/ask spreads of the ETF units & paid for by the transacting users. The ETF itself – and its existing investors – remain shielded from the associated trading costs.

So when people want to buy/sell ETF units, the costs are borne only by the transacting users who are entering/exiting the fund and not the buy/hold or long term investor. This is unlike mutual funds, where transacting & non-transacting investors alike experience a lower NAV due to the resulting trading costs.

How does this matter?

This inherent structure of ETFs is one of the main reasons why ETFs are considered to be one of the most important financial innovations ever – and it’s also why ETFs tend to have lower holding costs compared to similar mutual funds.

Now, think again about the kind of investor you are – are you the kind who isn’t planning to take out money in the near future? Did you (wisely) hold through your investment when others were panicking & selling during the market crash in Sep 2018? If so, that’s great for you – but then why should you pay for the transaction costs incurred due to the activities of other investors?

If you think that would be unfair, then ETFs are the right instrument for you.

*************************

This is the 3rd post in the ETF Education Series. If you are new to ETFs or interested to learn more about them, we recommend reading the entire series:

  1. ETF 101 – What is an ETF?
  2. ETF Liquidity, Creation, and The Role of Authorised Participants
  3. Why are ETFs Fairer than Mutual Funds?
  4. 3 Stock Market Crashes that changed Investing: Origins of MFs & ETF
  5. ETFs – Growth & Scope in India
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Vikas Bardia @https://twitter.com/vikasbardia

Investor + startup guy who loves to chase rooftop & sunset views. Go long and prosper! 🖖🏼

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Tags: External-ETFs External-Mutual-Funds

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