Other highlights from this webcast
- What is an ETF and how is it different from a mutual fund?
- Why invest in an ETF?
- How to invest in ETFs
- Understanding the ETF bid/ask spread
Talli Sperry: Hi, I’m Talli Sperry. Welcome to this evening’s live webcast on “ETFs—What you need to know.” Tonight, we’ll cover what are ETFs and why have they become so popular, common misconceptions about ETFs, and helping you decide if an ETF is right for you. Joining us tonight are Rich Powers, Vanguard’s head of ETF product management, and Josh Hirt, an investment analyst with Vanguard Investment Strategy Group, who will discuss what you should consider when investing in ETFs. Welcome Rich and Josh.
Rich Powers: Thanks, Talli.
Talli Sperry: We’ll spend most of this time tonight answering your questions. Two items I’d like to point out: There’s a widget at the bottom of your screen for accessing technical help. It’s the blue widget, and that one’s on the left. And if you’d like to read some of Vanguard’s thought leadership materials that relate to tonight’s topic or if you’d like to review replays of past webcasts, click on the green Resource List widget. That’s on the far right of you player. Sound good?
Great. Before we get into our discussion, we’d like to ask our audience a question. On your screen now, you’ll see our first poll question, which is, “Which of the following best describes your understanding of ETFs?” Very knowledgeable,” “Somewhat knowledgeable,” or “Not knowledgeable at all”? Please respond now and we’ll share your answers in just a few minutes.
So, Rich, while we wait, why don’t we go ahead and answer one of our first questions that was submitted by our audience, and that is, “What is an ETF?”
Rich Powers: That’s the perfect place for us to start. Let’s first break down the acronym itself. ETF stands for “exchange-traded fund,” a fund that trades on the exchange. So think of it as a mutual fund that is available to be purchased either on the New York Stock Exchange or the Nasdaq market. I think all of us are pretty comfortable and familiar with mutual funds. And the question might be, “Why are we talking about ETFs?” I think that the big answer for that is, “There’s a lot of interest in ETFs, particularly over the last 10 years or so.” What’s probably not well known is [that] ETFs are almost 25 years old. The first ETF in the U.S. was launched in 1993. So, it’s a pretty familiar vehicle in the marketplace, but it’s only in the last 10 to 15 years where more and more investors have come to appreciate that, largely because early days for ETFs, they were focused as investment vehicles for institutions, but now ETFs are being used by a wide array of investors. In fact, we’ve observed a meaningful uptake in investment across the direct retail investor, financial advisors, and institutions. We have a chart, actually, that speaks to the growth of ETFs over the last couple of years.
Talli Sperry: Could we bring that up? Let’s bring that up for our audience.
Rich Powers: What that chart actually speaks to is the rolling six-month cash flow into ETFs over the last 20 or so years. And what you observe over the last decade or so, but particularly in the last two to three years, is a meaningful spike in cash flows, and it speaks to this idea that ETFs are becoming more mainstream, more ubiquitous, and at this point, $3 trillion of investor assets here in the U.S. are invested in the over 2,000 ETFs in the marketplace.
Talli Sperry: So these are really time-tested products; they’ve been around for quite a while; people seem to be using them fairly frequently; they’re pretty stable products even though they might be new to many of us. Is that correct?
Rich Powers: I think that’s a great way to characterize it. And in many ways, an ETF is, effectively, the same thing that we all know and love with respect to mutual funds. ETFs have some additional features that make them different but, largely, the investment product that most Americans use to save for retirement or for education or for some other goal, ETFs kind of are built off that chassis.
Talli Sperry: That’s great. That’s good. So we’re already more familiar than we might think. Thanks for the insight, Rich.
Let’s take a quick moment and see how our audience responded to our first poll question. So when we look at “Which of the following best describes your understanding of ETFs?” we see that most of our audience, about 58% of them, are somewhat knowledgeable. And we’ve got about 36% that are not knowledgeable at all. I’m actually surprised that some of our audience, such a high percentage, are somewhat knowledgeable. Would you say that this mix is pretty consistent with what you hear?
Rich Powers: I think so. My team, along with some of my colleagues elsewhere, have studied this, and in terms of the adoption curve of ETFs, as I mentioned earlier, institutions were the earliest users of the product; and financial advisors, for a myriad of reasons, started to adopt them; and it’s only within the last 10 or so years where the individual investor has said, “This is an interesting product. It could have some utility for me as I’m building a portfolio.”
Talli Sperry: That’s great. So, as we continue, let’s ask our audience another poll question. And this one, for those of you who are familiar with ETFs and even for those of you who aren’t, because sometimes we do find people invest in products they may not know as well, and that question is, “Are you currently invested in ETFs?” And our answers are simple, “Yes,” “No,” or “No, but I’m considering them.” So, again, please respond now and we’ll get to your answers in just a few minutes.
Okay, so let’s take another one of our presubmitted questions right now and then we’ll see how our viewers respond. So, Josh, I’m going to give you this one. Actually, you know what? Rich, I’m going to give it to you. So let’s compare ETFs and mutual funds. I paused a little bit because you got into that just a second ago, but if you could maybe give us the top two or three features that are different, that would be helpful.
Rich Powers: Sure. Before I do that, if you don’t mind, I think an analogy might work here. So think about vehicles, right? You’re going to go out and buy a new SUV. There’s a myriad of different SUVs you can consider. Some of those SUVs have certain features that you might like and want to consider, but largely they’re offering the same thing, which is transportation somewhere, comfort. And so, I think of mutual funds and ETFs kind of falling in the same basket. ETFs and mutual funds are governed by the same regulatory structure. So the SEC is, in terms of how they think about looking after ETF investments, very familiar, very similar to what they do for mutual funds.
And then, too, mutual funds and ETFs are both pools of securities that help an investor reach some type of investment objective. So that pool can be of stocks; it can be of bonds; it can be a combination of both. So there’s those similarities that a lot of us are familiar with.
The differences really fall into three buckets. One is that with an ETF, you’re buying that security on an exchange. So think of the New York Stock Exchange or the Nasdaq. In contrast, with a mutual fund, often times you’re opening an account with a firm like Vanguard and going directly to them to buy the portfolio.
Two, for most ETFs, they follow an index strategy. About 99% of all ETFs today follow some type of index strategy, whereas the majority of mutual funds out there actually follow an active strategy, where a manager or team of investors are trying to outperform the stock or bond market.
The last key difference between ETFs and mutual funds would be that with an ETF, you buy and sell that security at prices between 9:30 [a.m.] and 4 p.m., [Eastern time,] when the stock exchange is open, so you can buy an ETF at 9:50 [a.m.], buy it at 11:30 [a.m.], buy it at 12:30 [p.m.]. With the mutual fund, there’s only one price at which you can transact, and that’s at the 4-p.m. market close.
Talli Sperry: But you can still buy them throughout the day, right? Even though the price stays the same.
Rich Powers: Right. With an ETF, you can buy at different prices. For a mutual fund, you can submit your order at any time of day. The price you receive will be the price that struck at 4 p.m. that day.
Talli Sperry: Okay. Great. That’s good comparison. I think we’re getting a little clearer, so thank you.
So let’s see how our audience has responded to our poll question so we know what our audience is in terms of investors. And when we asked, “Are you currently invested in ETFs?” we see that over 40% of you are. So that’s kind of fun. About 20% say, “No, they’re not,” and about 30% say, “No, but they are considering them.” So, hopefully, this discussion will be very helpful to all of you.
And with that, we’ll go back into the questions that you submitted, because it’s most important to us to answer your questions. So please feel free to keep sending them in.
This one, actually, I’m going to kick to you, Josh, and that’s from Doris in Sarasota, Florida, who’s asking, “Why do investors choose ETFs over individual stocks?” And I think this connects to Rich’s point about pricing throughout the day. And then she also asks, “Why do they choose them over mutual funds?”
Josh Hirt: Yes, good question. I think it is a good natural extension of sort of the points that Rich made in terms of mutual funds versus ETFs. When I think about why one might choose to invest in an ETF or a mutual fund over an individual security, most likely the reason that they are looking for there is to get the advantages of, one, professional management and, two, diversification. So rather than choosing the securities on their own, being susceptible to the risks that are inherent in that individual security, the risks that are inherent in that sector of the security, they are then opting for a more portfolio-level approach, where they are having a professional manager choosing those securities for them, and they’re taking advantage of diversification across sectors and across a number of different names.
So, in terms of the choice between ETF or mutual fund, I think this ties in really nicely with Rich’s points in that there could certainly be a number of factors that are going to influence this decision, but primarily it would be one who was looking to actually have access and use that trading flexibility that ETFs offer relative to the mutual funds that, while you can transact during the day, you’re going to be receiving the end-of-day price. ETFs allow that greater flexibility to really take out views on the market intraday, in the moment.
Some other things that could potentially lead in increasing that decision, I think Rich mentioned, also, this could be a decision doing your strategies. For the investor who is looking for an indexing strategy over an actively managed strategy, ETFs do offer—they’re predominantly index based, and they do offer some nuanced indexes that they follow that might not be available in the mutual fund market. And it also could just be an accessibility thing. Due to the fact that ETFs are transacted through a brokerage account, the brokerage account generally offers a broader array of access to investors than may potentially be available on a mutual fund platform. So it could just be as simple as someone looking for the same type of exposure, and it happens to be that they’re able to access the ETF relative to the mutual fund.
Rich Powers: One other point, I would add there too, is that the ETF might have an advantage in that generally the price to get into an ETF, or the entry point in terms of the dollars you need to come up with, is the price of the ETF itself, right? And so, you have a brokerage account; the ETF is priced at $100 as its NAV; you have to come up with $100 and you’re able to buy a share of that ETF. Most mutual funds have some other type of minimum investment whether it be $1,000 or $3,000, and so for that early investor who doesn’t necessarily meet those minimums, an ETF could be a good vehicle for them to get that diversification that they know that they want.
Talli Sperry: That’s helpful. Josh, I know you mentioned a little bit about risk. I’m reading a question and it’s from Randiv, and he asks, “Are ETFs riskier than mutual funds?” So you talked about it in comparison to stocks, but what about in comparison to mutual funds?
Josh Hirt: Sure. I think the ability to look under the hood of the ETF, so to speak, and the fact that you have that lens into what is happening in the market at any given time during the trading day, that you’re able to see prices, that can sometimes lead investors to think that they may be more volatile or more risky. I think what we would point to is that very underlying fact, is what’s happening in the mutual fund market; it’s what’s happening in the market now. ETFs are giving you that lens into exactly what the underlying market is looking like. So, really, minute by minute, you’re able to see the views of investors and what they’re taking that out in the markets.
So, in terms of risk, there may be volatility that appears to be something that’s more than a mutual fund, right? You may see price movement throughout a day. That’s also happening in the underlying mutual fund. You’re just not able to see it.
So, I think in terms of risk, while there are features that are different, and there are some things to get comfortable with, in general these are vehicles that are to facilitate investor exposures to very similar asset classes. That’s really what’s going to drive the underlying exposures that investors receive—is the markets of the asset classes that they’re invested in.
Talli Sperry: That’s helpful and it leads into our next question. So thank you for continuing to submit questions. Please keep them coming. It’s such a joy to have you a part of our discussion. So this one is from Lisa, and she’s asking, “Do ETFs actually own the stocks within them?” So I think this dovetails nicely from where you were going. So I don’t know, Rich, if you want to throw this a pass.
Rich Powers: Sure. I think it comes back to the concept we talked about before, which is [that] ETFs and mutual funds are effectively doing the same thing, offering the same type of exposure to investors but just different features. A mutual fund does securities that it owns. Every investor who owns a pro rata share of that fund, owns a pro rata share of the securities that represent that portfolio. Same thing happens with an ETF. And so, the structures are identical. You’re getting exposure to this portion of the technology market or this portion of the industrials market through your ownership of something like a 500 index fund. You own those securities as an investor in the ETF or the mutual fund.
Talli Sperry: Okay, great. So let’s go ahead and move forward into some of our presubmitted questions. We’d like to get through as many of those as we can, but again, feel free to keep sending your own.
So this one is from Wyche in Dallas, Texas—I just was there—who asks, “What are the primary differences, advantages, and disadvantages of ETFs versus index mutual funds?” So we covered some components of this, but let’s try to give it a good summary. Josh?
Josh Hirt: Yes. I think we did do a reasonably great job of covering most of the key differences, advantages. I think I would just highlight two that maybe we didn’t touch as deeply on. And one of them is a very simple feature, but it also relates to how investors can potentially use ETFs versus mutual funds. And that is, by nature of them trading on exchange, it does create an additional responsibility on the part of the investor to actually execute. So going into the market and executing on the exchange, that actually creates some problems in terms of automatic investments. So something that is a small feature, it could be looked at as an advantage or a disadvantage.
Talli Sperry: Because some clients really value that feature, right?
Josh Hirt: Without question. Especially, as you would get into maybe longer-term investments—potentially retirement accounts, where having automated investment is really a good feature where you can just let it run in the background and you’re continuously doing that—the ETF structure makes that considerably more difficult. It’s generally not available for the ETF structure.
Talli Sperry: So we just have to know what we want, right?
Josh Hirt: I think that’s a key one. The other thing would just be coming back to that additional responsibility that is now on the part of investors. So again, the trading flexibility is something that is really a key advantage of the ETF if that is a feature that someone is looking to use. However, that does create the additional responsibility of being able to be aware of market conditions as well as executing appropriately so that the trade will go on as seen.
Talli Sperry: So it sounds like there is a little more knowledge we would actually need about the market. And this I found interesting as I was sitting with some of our ETF traders, and even just studying for this webcast: We really do have to understand a little bit more than we might otherwise. So I do want to take a minute and point you to the green Resource widget. That’s really helpful. It’s got a couple of explanations of some of the things that we’re talking about, and it’s also got some good myth busters.
So Rich, you’ve written a few common misconceptions that are in there. So, those could be really helpful in continuing to educate us in this space.
Great. Thanks, Josh.
So let’s take another question here, and let’s look at Maria’s from Stoneybrook. And Rich, I’ll throw this one to you. And she’s asking, “Are ETFs riskier than mutual funds investing in the same stocks?” So we covered, “In general, are they riskier?” But let’s nuance on that in the same stocks piece.
Rich Powers: Right. So let’s stay with the 500 index product. It’s the first index fund available in mutual fund form for the masses. It was launched more than 40 years ago. There’s a mutual fund version of that [Vanguard 500 Index Fund], and there’s an ETF version of that [Vanguard S&P 500 ETF] that Vanguard offers. The exposure offered by both of those portfolios is identical—the 500 stocks. They’re in equal proportion to their market weight in the benchmark. And so, the experience that an investor has in that product, whether it be in the mutual fund or the ETF—identical.
Now as Josh was alluding to, the different experience might arise as a consequence of someone’s trading decisions. So I might decide that I want to make an investment in the mutual fund, and I’m going to submit my $500 investment after I’ve already opened my account, and I’ll get the fund’s price at the end of the day, at 4 p.m. So I might buy that, just making it up, at $200 per share. The same person on the same day might decide, “I’m also going to buy $500 worth of the ETF.” They have to make a decision as to how they’re going to execute that trade, and it’s highly unlikely that they’re going to have the same price achieved in the mutual fund, because they’re going to buy that ETF at some point between 9:30 [a.m.] and 4 [p.m.], and the price more than likely will be different from the closing price of the mutual fund. So that’s the really only difference. Otherwise, the experience, the exposure, the long-term returns that investor realizes will be identical.
Talli Sperry: Okay, great. So how do we start to think about this pricing piece? I think you’re mentioning they change throughout the day; we need a little bit more education; we may get different prices. What level of control, for lack thereof, do we potentially have as investors here?
Rich Powers: As far as executing, right? So as Josh alluded to, I think the ETF does put a little bit more onus on the investor towards the decisions they’re going to make. When you’re executing a trade, you have the ability to use a market order, which allows you, basically, to get your order executed as quickly as possible. You’re not that interested, not that concerned with the price that you receive; you just simply want to be in the market. You could also use a limit order, and in that case, you are really focused on the price that you achieve when your order goes to market. And so, perhaps, it takes a while for that order to be filled because the price range of the ETF isn’t where the limit order is that you’ve placed. And so, that’ll be a key difference—and perhaps a responsibility experience difference—that ETF offers relative to, say, a mutual fund.
Talli Sperry: So, again, it’s about knowing what we want. Do we want to be in or do we care about a certain price point, right?
Rich Powers: That’s right.
Talli Sperry: Okay, great. So we have one more live question, and this one, it looks like Thomas is asking, “Are dividends and capital gains able to be reinvested automatically in the ETFs?” Josh, maybe I’ll throw that one to you?
Josh Hirt: Yes. I would come back and say that definitely these, again, focus on the key parts of ETFs and the key parts of the mutual funds that are very similar. There are many of these elements that are—whether it’s taxation or whether it’s the dividend side of things—that can be handled very similarly. In terms of investing them, you generally can reinvest those through that same process that you’d be able to have on the mutual fund side.
Talli Sperry: Okay, good. That’s good news. So we’re going to go to one of our presubmitted questions, and, Josh, this one is from Paulette in Oakland, California. And she’s asking, “What are the costs associated with ETFs?” So we started to get into this a little bit, but let’s dive further. Can you explain just how we should think about cost broadly with ETFs?
Josh Hirt: Sure. I’ll come back. ETFs and mutual funds—you’re going to have some similar costs with some potential additions. I would say the biggest comparison with both—and with ETFs you’re going to have ongoing costs and transaction costs. Ongoing costs—generally we’re talking about expense ratios. So these would be the types of costs that you will incur to run the fund: Pay salaries, rent, administration. Really, behind the scenes, what does it take to actually get the fund run both from the money management side and the administrative side of it? A lesser, maybe, thought of ongoing cost would be taxes. So something that can be a drag on the portfolio—it’s not exactly front and center, something that you can look at immediately, but it is something that will play a role in your portfolio long-term.
In terms of transaction costs, again ETFs have them; mutual funds have them. Mutual funds have them sometimes in the nature of redemption and purchase fees, and ETFs have them in the form of commissions. So you might be charged a commission when you trade an ETF, but then you also have things such as the bid-ask spread. So, really, this is a function of them trading on exchange. Again, this is, primarily, instead of investors transacting with the fund as they do in a mutual fund, in the ETF, investors are transacting on exchange with each other. So, buys and sells are being matched, and you have somebody that’s facilitating that, that is charging a fee to facilitate these trades. That’s really where the bid-ask spread comes in. So you’re paying something that is slightly different from maybe what the underlying value is, that’s as a service for matching the buys and sells.
Talli Sperry: That’s helpful, and we actually have a really good chart for you on this. So I’d love to bring that up right now if you’re okay with that. And on that note, we have Mitch asking, “Can you explain the bid-ask spread for ETFs?” So I think this is perfect timing, Mitch. We’ve got our visual for you, and then, Josh, I’m going to ask you to just walk us through a little bit, how to understand the visual.
Josh Hirt: Yes, sure. I think so. And Mitch, write back if we don’t clarify here as well, but I think part of my initial answer gets to some of that. What really is the bid-ask spread and what are you paying for? Again, it’s a function of you trading on exchange, and so, to match these orders, there is a service that’s paid for that. Essentially, looking at what out there in market is the best offer, the best that someone is willing to sell at, or the best bid, the best offer that someone is coming and saying, “I will buy this security at this price.” In between there, there is that spread that’s charged to really facilitate that.
Talli Sperry: So in our visual, the top half is that sell space you were talking about, right? And the buyer would probably be asked if we’re actually buying the ETF, and then the spread you were talking about, that middle space in the chart, that’s our bid-ask spread we keep referencing. Is that correct?
Josh Hirt: Correct.
Talli Sperry: All right. Good. So feel free to let us know if you’d like to see that visual again or if you’d like more clarity there.
Right now we’re going to jump to another live question, and this one is from Jan. And she’s asking, “Can ETFs be used in conjunction with IRAs and Roth IRAs?” So, Rich, you’re nodding at me. I’ll give that question to you.
Rich Powers: Yes. ETFs can fit the bill for really nearly every investment account you could think of. Because they’re just like mutual funds, they fit in those types of portfolios. What you would probably want to do first is think about what the investment strategy is of the portfolio that you’re choosing. So, for instance, and this is where Josh is maybe even more expert than me, but if you’re thinking about making an investment in a fixed income ETF, you probably want to think about putting that into an IRA investment because that’s tax-sheltered and there is a greater tax incidence with fixed income investments because they’re constantly paying dividends. With an equity index fund, it could fit in an IRA or could also fit pretty well in a taxable account. So, yes, ETFs have utility in nearly every account you can really think of: IRAs, long-term investment accounts for kids’ educations, or just a general taxable account.
Josh Hirt: I was just going to say, it seems like we’re getting a lot of questions about, is it appropriate for this? Is it appropriate in this instance? And I think, again, really come back and think about the two structures: we’re much more familiar with mutual funds and ETFs facilitating some very similar things. And we think about a question about retirement, one of the most important things you can get right in that scenario is your asset allocation, and ETFs can certainly be used to facilitate that in the same way.
Talli Sperry: Yes. I like where you were going both of you in this. Focus on your goals and why you’re doing what you’re doing, because at some point, it’s a little bit less about the exact vehicle that is being your first choice but really knowing why you’re doing what you’re doing being your first choice, and then the vehicle support that choice.
Josh Hirt: I think we would say that the ETF or the mutual fund or any other vehicle is a choice about implementation, not about strategy. So an ETF is not a strategy, but it is a tool for implementing a strategy.
Talli Sperry: I love that verbiage. That’s really good.
So let’s jump to one more question. This is from Richard from Chicago, Illinois, and he’s asking, “Please walk me through the mechanics of the trade and break down the different ways an order is specified.” So, Rich, you got into this a little bit with the market order and the limit order, but what more can you tell us about some of the specifics and the way those are executed?
Rich Powers: Sure. Again we’re assuming investors have done their homework and decided this is the right type of investment strategy. At that point, they’re going to go to the order path within a given brokerage firm’s platform, and they’re going to say, “Well, I value speed and execution.” And in that case, they’ll choose a market order, and that market order will go to the market and very likely be filled relatively quickly within a few minutes’ time. In the case of a limit order, that investor’s saying, “I want to be really careful about the price I actually receive for the order than I’m placing.” And so, it might take a little while for that ETF’s price to get across into that area in which the investor said, “That’s where I want to get involved.”
And so, the risk that investors run is that their order may not be filled in a given day and may kind of stretch out over a couple days, but they prioritized the price they pay over speed. And that’s perfectly acceptable. And I’d say we would generally caution investors to think about using limit orders. Actually, encourage investors to think about using limit orders over market orders given the volatility you might see in the market and in a security’s price kind of moving away from you rather rapidly.
The other thing you have to do with an ETF that you don’t necessarily have to do with a mutual fund is specify the number of shares you want to trade. So with a mutual fund, if you wanted to buy shares of a mutual fund, again coming back to our example, send your thousand dollar check in, whatever the price of that mutual fund is on the day your check arrives, that’s how many shares you get. With an ETF, you have to look at your brokerage account and say, “What’s my balance? What do I have available to spend?” And then look at the price of the ETF and identify what number of shares are you willing to purchase given what you have available. So that’s another step, not complicated, and most brokerage firms have a calculator for you on their site to allow you to quickly go through that math. But that’s a difference relative to what people are used to with mutual funds.
Talli Sperry: That’s great. And I want to go back to something you said about the price moving away from us quickly and the importance of that limit order, because for many of us, we’re cost-conscious and we know what we want to spend. So just keeping that top of mind, so things don’t move quickly beyond where you wanted them to, is really an important point I want to draw out for us.
Rich Powers: Absolutely.
Talli Sperry: Great. So let’s go to one more live question. This is from Steve—thank you—and he’s asking, “Since the spread between bid and ask is the cost of closing the deal, does the spread always stay the same or is the spread dynamic? And if it’s dynamic, what drives the change?” Josh?
Josh Hirt: It’s a very good question. Absolutely, it is dynamic. So it’s as much in the capital markets; it is extremely dependent on the environment in which we are living currently at that point in time. So it would also be affected by just overall volatility in the market. If they have something that is going on in the market—events such as Brexit, elections, geopolitical events—these are things that can certainly affect how bid-ask spreads could change, widen, narrow, etc.
Maybe a helpful way to think about the bid-ask spread as well is [that] this is the price that is being charged, essentially, for the risk that is being borne in facilitating this trade. So as environments tend to get more risky or more uncertain, that can be a scenario that causes the bid-ask spread to widen out. Even within a specific asset class, while that could be the case, you’ll have changes within asset classes in general as well. So you may see much tighter bid-ask spreads for a very liquid, very efficient asset class such as U.S. equities. That would be a different level of bid-ask spread for something such as corporate fixed income. So, absolutely very dynamic and it can change.
Certainly, there are levels that are in ranges that tend to be where things come back to, but they are dynamic and can change.
Rich Powers: It’s really important, too, to talk about that the spread of an ETF is driven by the spread of the underlying basket of securities that it represents, right? So, as Josh was alluding to, large-cap U.S. stocks probably have a tighter spread than, say, small-cap U.S. stocks because the spread of blue-chip types of companies ends up being tighter because those stocks are traded very frequently and by a wide array of market makers. And so, the ETF is always going to reflect the underlying security exposure from a spread standpoint.
And, in fact, the ETF might actually be able to give an investor tighter spreads than they would experience if they went out and bought the underlying individual securities, and that’s because, as we were talking about before, you’re not interacting with the ETF fund sponsor, right? You’re interacting with other market participants. So that level of trading that’s happening will necessitate, potentially, a tighter spread versus going out and assembling those 50, 100, 500 stocks yourself.
Talli Sperry: And it makes sense that the spread would be dynamic because you’ve got multiple parties involved, and they’re each making different decisions at different points in time, when you think of the top and bottom half of our graphic a bit ago. So that makes perfect sense. I think one thing you’re pointing out, again, is just this knowledge of the markets, and that’s the fun part of these products. You actually get into understanding the markets a little bit more broadly.
So I do want to draw you back to the green Resource widget. That was actually a really fun place for me to study a bit when I was preparing for this, and I enjoyed just all of the extra knowledge. It made these products just more exciting and more enjoyable to dive into. So I just encourage you to read there as well.
All right. So let’s go back to some of our presubmitted questions, and let’s look at Pamela from Rollinsford, New Hampshire, who’s asking, “Please discuss the tax efficiency of ETFs.” So, Rich, I’m going to give this one to you, and we made a slight allusion to it earlier. I think, Josh, you mentioned taxes a little bit. So can we elaborate?
Rich Powers: Sure. So if you were to pick up any newspaper, any kind of white paper or research article on a company’s website, what you’d see is ETFs are a tax-efficient vehicle. And largely the reason why ETFs are considered a tax-efficient vehicle is because of a point we made earlier—that most ETFs use an index strategy. And with an index strategy, you tend to see less change or turnover in the securities that represent that index. Certainly relative to, say, an active fund where the manager is looking at this stock versus that stock and saying, “Well, my thesis is broken down here. I’m going to sell that stock and buy this one.” So you tend to see lower turnover. And what that means is that the portfolio overall ends up selling fewer securities that have appreciated a lot and, therefore, create a capital gain. So that’s kind of at the core of ETFs as to why they’re tax-efficient. That same concept holds true for index mutual funds as well because, as we talked about, index mutual funds and ETFs are largely doing the same thing.
There is another dimension to ETFs that’s a little bit different, and that’s the process in which securities enter and exit that ETF. So in a conventional mutual fund, we send our dollars in, the portfolio manager takes those, invests them, and at some point, we extract those dollars, and the portfolio manager has to go out and sell those securities, and maybe some of those securities have appreciated in price, potentially creating a capital gain.
With an ETF, if there are more investors trying to leave that portfolio than enter it, the portfolio manager, to satisfy that need, will hand that basket of securities that represent the redemption request to a market maker, and that market maker will handle the selling of those securities to meet the investor’s need for the redemption. And so, the portfolio is never selling securities within its construct and, therefore, not generating capital gains that are passed along to the remaining investors. And so, that’s the additional part why ETFs can be a bit more tax-efficient than what you might see in a conventional mutual fund.
Talli Sperry: It sounds like a really nice feature to the product.
Rich Powers: It’s powerful, and I think often times what gets twisted a bit is that investors, or those in the news media, might go to the in-kind feature as the leading reason why an ETF is tax-efficient. Ninety percent of why it’s tax-efficient has to do with the strategy that’s chosen and because it’s indexing. That’s the leg up often times.
Talli Sperry: Okay, that’s good clarification. Thank you.
So we have another live question. So, Judy, thanks for asking, “For a market order of an ETF, is there a time of day that’s best to buy or sell an ETF in general?” This is a good one.
Josh Hirt: Yes. It’s a great question because we definitely have some general practices that we think are appropriate for trading. Most of them, Rich touched on. The only things I would add to that are specifically around time of day, really a key thing. If we take it back to where we were talking about, volatility and the uncertainty and what that has to do with cost, think about the morning of an open. You typically have price-setting behavior, not all participants are online, and it definitely takes some time. You see a volatility that is greater in the morning than you might throughout the rest of the day. Likewise, at the end of the day, to some degree but certainly, we would advise—let at least the first half-hour, hour of the market clear before transacting. It just allows for greater price transparency to really get the underlying value that’s not being caused by any volatility. So that would certainly be one piece that’s really key.
Along with timing, I think what I’ll also just mention a little bit, and we haven’t discussed international ETFs, but they do provide this other element of timing, which comes in as well, and within international markets you have the opportunity for an ETF to be trading here in the U.S. For instance, say, you’re trading a European equities ETF, there could be a time of day where the ETF is trading but those underlying securities aren’t actually trading in the local market.
Talli Sperry: Right.
Josh Hirt: Picture an event close to the end of a U.S. market day: European markets are closed, maybe some type of a geopolitical event, something that would move markets. ETF investors can take those views out and recognize what’s happening with the ETF immediately. Those underlying securities aren’t trading, so there is a larger disconnect. So, again, our advice would come back to: Find times when the local market and the ETF are both trading at the same time. We’ll just have a better experience for execution.
Rich Powers: Can I build on that? The idea of the market open there is really, really important. The ETF market price is derived from the value of the underlying securities that it holds. And so at the beginning of the market day, 9:30 [a.m.] or so, not every underlying security has been opened for trading. And so, as a consequence, market makers, the folks who are kind of pairing off Josh’s trade with Rich’s trade, are going to say, “I’m not sure what the price is of a handful of these securities, and so I’m going to make my spreads a little bit wider to cover me on that risk that I would be taking.” And so waiting till everything’s open and, by Josh’s point, 30 minutes in, you’re going to be pretty safe. You’ll get full price discovery in the market and, therefore, probably a better experience and a tighter spread than what you otherwise would receive.
Talli Sperry: That’s helpful, and I think it reminds me of something you said earlier, Josh, which is about risk influencing price or perceived risk in the market; and I think that’s directly what you alluded to, so definitely good to keep in mind.
We have another question, and this is from David. So, David, thank you. You’re asking, “How concerned should I be about liquidity in ETFs should the market be dropping and I wish to exit?” So this is something that I hear often; we see often in the news; it’s top of mind for people, this liquidity piece.
Rich Powers: I’ll get started; and Josh, feel free to jump in here. So the liquidity of an ETF is derived and driven by underlying securities in that portfolio. And so, if you’re operating and investing in a portfolio that’s in U.S. large companies and even U.S. small companies, there’s a high level of liquidity in those underlying stocks and, therefore, to the extent that you decide that you want to exit a position, probably in a pretty good spot, and a likely probability that the liquidity will be there, particularly for investors trading in relatively small lots. For those investors who are moving $10 [million], $20 [million], $50 million in a portfolio, the sensitivity around liquidity becomes far more heightened. In that case, they might want to deal with a company’s block trading desk to help them execute that trade.
But if we’re talking about a $1,000, or $2,000, or $10,000 trade, liquidity’s probably not that big of a deal or a concern, because it’s going to be there in a broadly diversified strategy. When you start venturing into more esoteric investment strategies, focused on a really tiny part of the market or very specific small countries, for instance, or a small part of the fixed income market, that’s when you might be venturing into a place where there’s not a high level of natural liquidity, and so you want to be careful there. But your kind of broad market index funds—500 index, total stock market, total bond market fund—they’re going to have high levels of liquidity for nearly every situation that investors who we’re talking to tonight could think of.
Josh Hirt: And if I could just jump in, some of what helps out is that you have this exchange-traded nature. So you have this tremendous pool of investors anywhere, the three of us beyond, that are able to transact with each other and not affect the underlying securities.
But, something else to remember about liquidity is that it doesn’t always mean you’re going to get the price you want. So part of the ETF, again, I think something we alluded to, is that the ETF is really giving you a very clear and direct view into what is happening in underlying markets, really, as events occur at any given time. So will there be someone to take the other side of that trade? Very, very likely, if not most definitely. It might not be the same price that you’re wanting, but you will be able to find someone to get that transaction. It just might be at a price level that you may not have seen a day or two before, especially if we’re talking about some kind of a scenario with markets moving.
Rich Powers: One kind of broader theme on this is that one of the common critiques you hear about ETFs is that they might incentivize investors to trade against their best interests. So kind of the running for the exits when the markets are down, when, in fact, maybe the right thing to do would be to sit tight or maybe add more. And so the flexibility an ETF offers is often criticized. But the facts are, when we observe the behavior of our investors on our brokerage platform and the many financial advisors to be observed in the marketplace, that folks don’t use that feature of trading very quickly in an ETF. It’s a feature. Some folks will find it valuable. Most actually don’t. They use ETFs as a long-term investment vehicle.
Talli Sperry: That’s helpful. So that helps frame our mind about maybe how we should think about them too. Really helpful.
Rich Powers: Absolutely.
Talli Sperry: So we’ve got a question from Gerome, and he’s asking, just in line with this, “Are ETFs appropriate for a buy-and-hold strategy?” So perfect timing, Gerome. I think you’re on the same wavelength as the rest of us here. So, Rich, I’m going to guess your answer is, “Yes”?
Rich Powers: Yes, absolutely. I think ETFs can fit a buy-and-hold strategy just as well as a mutual fund can. As we talked about before, the reasons why someone might prefer the ETF over the mutual fund might be maybe there’s lower commissions for the ETF relative to the mutual fund. If they’re not buying the ETF on the issuing firm’s platform, they might buy the ETF because it’s a lower hurdle rate in terms of the dollars they need to come up with to make that purchase. They might buy the ETF because the do maybe have a shorter-term time horizon than what otherwise might be appropriate for a mutual fund. Perhaps they want to make an investment in a short-term vehicle because they have a house closing on the horizon or a tuition payment. They want to use a short-term bond ETF as a vehicle for that. That’s a perfectly acceptable vehicle.
So ETFs are absolutely suited to be binal. They have trading flexibility. But, like I said before, [it’s] not often that people actually take advantage of that. Certainly not the clients that we interact with.
Talli Sperry: That goes back to knowing your goals so then you know how to use the product. Great. So let’s get a little bit more specific. We’ve had a good general discussion broadly about ETFs. And so, Rich, I’d like to ask you, “What are the two most important factors when comparing two similar ETFs? And Habib is asking, “What ETF products does Vanguard offer?” And perfect timing because we have a very special day at Vanguard today in terms of ETFs. So, Rich, can you share with us?
Rich Powers: Sure. So, Habib, thanks for the question. This topic’s near and dear to my heart in terms of the factors one needs to consider when evaluating two similar ETFs.
So I think one place you start is cost. If you’re looking to invest in a large-cap U.S. ETF, I think a nice starting point is, what’s the expense ratio for the product? From there, I would spend some time understanding, what’s the strategy of the underlying index? Not all indexes are created equal in terms of the exposure they provide. So try to understand what the differences are, say, in the strategy. Maybe one of the indexes has more midsize company exposure than the other. And so that’ll lead to different outcomes.
As Josh is pointing out, spreads are a really important thing to keep in mind. One product might be larger and trade with a little bit more volume, and, therefore, the spreads are tighter than the other. So I think those are a couple of places I would start.
Certainly, the brand of the firm I think is a big deal. And certain firms take great care in the products they roll out to ensure that they’re meeting the needs of the investors they’re trying to serve.
Talli Sperry: And we’re one of those, right? We’ve had a very targeted approach with our ETFs versus a broad approach.
Rich Powers: Yes, I would absolutely say so. And that brings us to the Vanguard lineup. And so we have 71 ETFs in the Vanguard lineup. The 71st ETF was launched today, in fact, our Vanguard Total Corporate [Bond] ETF, which is a portfolio that invests across the short-, intermediate-, and long-term portions of the U.S. corporate bond market. And so for us to bring a product to market, it takes a really high hurdle rate. And that hurdle rate is based upon, is there an enduring investment need that this product can fill? And is there an investor out there who would find this useful in helping them achieve some type of goal?
There are other considerations as well in terms of our skill level in delivering that type of product, and can we do it at low cost? And so we’re very patient about that, and so that’s why you’re less inclined to see Vanguard launching a lot of products in a given year because it takes a while. We want to put a great product out there for our investors to use.
Talli Sperry: So it’s fun that we got to actually be together on the day of a launch because it’s a bit more of a rare occurrence.
Rich Powers: That’s exactly right.
Talli Sperry: Because we are that conscientious.
Josh Hirt: If I can just come back to one point Rich made I think was really good too just about firm brand’s name, remember most ETFs are index strategies. So ETFs ultimately—the ability for them to track the index that they’re looking to follow is really paramount. Certainly something to consider in terms of who has indexing expertise and tracking error, how does that ultimately show up really is something that’s important for investors.
Talli Sperry: Yes, having a firm that’s very conscientious around those pieces is very key. Okay, great.
“So when we think about ETFs compared to mutual funds, …” This is a question from Steven. And he’s asking a bit of a nuance to something we discussed earlier, but I think it’s worth revisiting. And he’s asking, “ … ETFs compared to mutual funds, do they have greater day-to-day volatility?”
So we talked about pricing at the end of the day for the mutual fund, ETF throughout the day; but if you compare day after day over a period of time, do you see greater volatility?
Josh Hirt: Yes, I can take a stab at this first. Again, if we’re comparing two ETFs or an ETF and a mutual fund that are invested in the same asset classes, you really should not have a different experience. Again, you’re able to see what is happening under the hood intraday, and you can see what the price volatility may be. That’s also happening in the mutual fund. Just not something you’re directly able to observe, so I would say you’re going to have a very, very similar experience.
Talli Sperry: Okay, great. So we’re going to take another of our presubmitted questions, and this is from Jake. And he’s asking, “Are ETFs good for both short- and long-term goals? So, Rich, I think you touched on this a little bit with some of your examples, but just so our audience doesn’t miss it, Josh, could you give us just some of your mindset behind it from your research?
Josh Hirt: Yes. They’re good for short- and long-term goals. No, I mean I think—
Talli Sperry: Summary, right?
Josh Hirt: Right. I think everything we’ve talked about really encapsulates this. Investors—the primary purpose is for them to asset allocate, to get investment exposures. There are some different features that you may need to get comfortable with if primarily that revolves around the trading aspect, the trading flexibility that you had with ETFs. But if that’s a feature that appeals, that is something that could certainly be taken out in short-term or long-term goals; can really use both of them to get investment exposure, and that’s the primary goal for both of those.
Rich Powers: It’s not “either/or,” right? It actually can be “and.” You can have a part of your portfolio maybe in some actively managed mutual funds. You can have part of the portfolio in index-based mutual funds, and then perhaps if you do have a shorter-term need, the ETF is a better vehicle for that short-term need.
Likewise, you could say, “Well, I like these actively managed managers in my mutual fund space. I want that for the long term. I also want this long-term allocation in the ETF to fixed income.” They work together. It’s not as though they’re mutually exclusive that you have to be in the ETF camp or the fund camp. It’s the power of “and,” and they both work together.
Talli Sperry: Yes, I think that I like your thought on the power of “and,” both with them in relation to the same goal and then also to different goals. Your portfolio can have different goals. Good.
So let’s go to our question from Saswato, who’s asking, “How can ETFs be used to gain exposure in fixed income universe?” So, Rich, this feels perfectly timed for you.
Rich Powers: Sure. So there’s a range of options that are available in the ETF wrapper related to fixed income but, also, ETFs in fixed income are relatively new versus ETFs in equities. The first ETF was for an equity product and then, effectively, they were in equity products for the first 10 years of their lives. So from the early ‘90s to the early 2000s, every ETF was a stock ETF. And then about 15 years ago, the first fixed income ETFs were launched. And so you’ve seen a buildout of different options from various sponsors covering different segments of the market. So whether it’s the Treasury market, the corporate market, the international bond market, or a portfolio that kind of rolls it altogether, like a Barclays aggregate or a total bond market fund, there are different options for investors based upon their time horizon, risk tolerance, and their focus, and where they see an opportunity for investment. So lots of vehicles to choose from and for the various goals that those investors have.
Talli Sperry: Great. So, Josh, you referenced international ETFs just a little bit. And Joe is asking, “Could you please discuss them a little bit more?” So, would love to hear from you.
Josh Hirt: Sure. Think of them very similarly as you might think about a domestic equity ETF or a domestic fixed income ETF. Again, you’re really just using an implementation vehicle that’s now giving you exposures with some additional features to different markets. I think the key thing to keep in mind with international ETFs is just the timing difference. So as you’re looking to trade the ETF, there are going to be some mismatches potentially in when the underlying markets are open versus the ETF. I think those are the biggest things to keep in mind. But these are just ways to get exposure. So international ETFs, domestic ETFs—think of them in a very similar fashion.
Talli Sperry: And when you say things to keep in mind, you’re speaking in terms of pricing—right?—for the markets opening at different times and the pricing occurring. The price we would pay would be affected by that.
Josh Hirt: Exactly. So maybe I’ll step back. The ETF holds the underlying securities that are traded in local markets. And we have, for instance—again, the example I used earlier was a European ETF that’s here in the United States where we can trade and take out views or buy and sell the ETF.
If the local market is closed, we’re actually buying something when the actual underlying securities are not open. They’re not being traded currently. So we actually would be the only ones trading, taking views on the market at that point in time. That tends to lead to larger disconnects between what the underlying value of the securities is and what the ETF actually is trading at.
Talli Sperry: So that risk that Rich referenced.
Josh Hirt: Absolutely. So it’s just that enhanced degree of uncertainty. You want to get those as aligned as possible. And the best way to do that is to try to time a transaction when a local market as well as when the ETF is actually trading. So just if it was in Europe, trade earlier in the U.S. day around late morning, and both markets will essentially be open. You’ll have a better chance of being aligned.
Talli Sperry: Great. So we need to know our time zones too.
Josh Hirt: Yes.
Talli Sperry: Fun. Good. And in the green Resource widget, I do think you’ll see some pieces related to international ETFs and some of the conversations that we’ve just had around risk and pricing as well.
So let’s take another of our presubmitted questions, and this one comes from Frederick in Friendswood, Texas. And he’s asking, “Should it matter whether an ETF is placed in a taxable account versus a retirement account?”
So we talked a little bit about IRAs earlier. We didn’t mention specifically taxable accounts. Josh, could you just give a little bit there?
Josh Hirt: Yes, sure. I would think about these in really similar ways that we’ve talked about: short- versus long-term goals, taxable versus tax-exempt. As far as the ETF vehicle itself, that part of it can work in both. Again, these can facilitate short- and long-term goals. A taxable account versus a tax-exempt account is something that’s certainly appropriate for the ETF to be utilized in.
Rich Powers: And if you’re investing in, say, a Treasury bond fund or a corporate bond fund, if you have room in your tax-free account, your IRA, I would start there, put that exposure there. But if you don’t, it can work outside that. For an equity index ETF, either place fits because largely what you find is the equity index ETFs tend to be pretty tax-efficient. They’re not throwing off as much dividends as, say, a taxable bond fund.
And then, finally, for a tax-exempt bond ETF, so a municipal bond ETF, those are already tax-advantaged investments, so you would never want to put that into an IRA or any other type of tax-advantaged account.
Josh Hirt: But, again, these are asset allocation decisions. So these are the same decisions you would have with a mutual fund, etc. This is just the way the ETF is certainly a tool to take that out, but that is an asset allocation type of decision.
Talli Sperry: Great. So I want to move us through a little bit of a lightening round so we can get to some of these questions that we’ve got left. So I’m going to start with Tina’s from Saint Johns, Florida. And she’s asking, “Can you discuss the scare stories about the possibility of an ETF meltdown or a significant market correction both in equity and bond ETFs?” So, Rich, in short, what are your thoughts there?
Rich Powers: Sure. So you can look back to 2008, a really troubling time in terms of market returns with U.S. equity markets down more than 30%. And what you saw is that ETFs stood up to that test really well. In fact, the level of trading that happened in ETFs has never been greater in any given calendar year. And so ETFs played a really valuable role in terms of price discovery and flexibility for those investors who wanted to get involved or wanted to take some money off the table.
And so I think they’ve been tested. The scare stories have a lot to do with people concluding that because ETFs can be traded rapidly, everyone will run out the door when the market goes down. The reality is that there’s a wide array of investor time horizons and risk tolerances. Many investors will be investing on a regular basis. Some might want to take some money off the table, but it’s not as though we all are kind of this homogenous group of investors.
Talli Sperry: I think that’s good. We forget how long these products have been around. And I think even as we get further from 2008, sometimes we forget about that too. So I’m glad you brought us back to that timing.
So, second part of our lightening round—this one’s for you, Josh, and this is from Gerald from Ballston Lake, New York. And he’s asking, “If you like having a simple portfolio, should it be all ETFs, all mutual funds, or a combination?”
Josh Hirt: I’ll go back to something that Rich mentioned earlier. It’s not “either/or,” it’s kind of “both”; it really can be both. The simplicity is, they have different features. You know, a mutual fund does not allow the opportunity to trade intraday. That may appeal, that may be simple for someone. The ETF, once you’re in, essentially, can be a very long-term vehicle where you get a little bit more price information during the day if that was something that you were looking for. But, again, that could also be very simple for someone. They want to execute as a certain time during the day, but then they’re going to sort of set it and forget it.
So I wouldn’t think about these as “ETF is more complex, mutual fund is simple,” or vice versa. I think it’s really a mix of the preferences that people would use them for and, ultimately, how investors feel about them. I think they both can be very simple structures in either of their own ways.
Talli Sperry: So this is back to our “and” space, which is good. So I genuinely wish we could go on. I’m learning a lot and this is fun, but it does look like we’ve run out of time. So thanks so much for sharing your insights.
Do you have any final closing thoughts, one or two things you’d like to leave us with? Josh, maybe we’ll start with you.
Josh Hirt: Sure. ETFs and mutual funds are more similar than they are different. I think I’ll stop there.
Talli Sperry: That’s become very clear tonight, which is good.
Rich Powers: I think one of the beautiful things about ETFs in their eyes is that an investor is able to build a globally diversified portfolio at a really, really low price in a very simple way and not having to have a ton of capital to do so. Whereas many years ago, building that globally diversified portfolio was only the domain of the institutional investor who had a lot of capital to work. And so that’s exciting. The ETFs have helped democratize the investing world.
Talli Sperry: So for those of us who are just more everyday investors, we get access to more than we might otherwise have had.
Rich Powers: Absolutely.
Talli Sperry: It’s really fun. Good. Great. Well, thank you both so much for your time.
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