We believe that carefully selected active Exchange-Traded Funds (ETFs) may provide benefits to investor portfolios. Actively-managed ETFs have proliferated in recent years and appear to be in demand by investors. Here we discuss three common reasons investors favor ETFs, including tax efficiency, relatively low expense, and intraday trading on an exchange. While we generally agree active ETFs may provide these potential benefits, we also believe these features warrant further discussions and careful consideration.

 

Tax Efficiency

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The Backstory. The touted tax efficiency of ETFs compared to mutual funds stems from the way in which ETF shares are created and redeemed. When new investors want to invest in a mutual fund, the fund company receives cash from investors and issues them new fund shares. By contrast, ETF shares are created through a create/redeem process using Authorized Participants (APs). The APs are typically large institutions that help the ETF create or redeem shares by responding to rising or falling demand of an ETF. When there is demand for new ETF shares, APs buy the underlying stocks of the ETF and deliver them to the ETF issuer, creating ETF shares. When investors want to exit an ETF, APs take delivery of securities from the ETF, cancelling the ETF shares.

 

The Benefit. ETF managers who are keen to minimize taxable events have the option of delivering custom baskets of securities to the AP. They can choose to deliver out shares with high embedded gains, ridding the ETF of future tax consequences from an eventual, potential sale of shares.

 

The Burden. For an ETF to truly be more tax efficient, the ETF manager must be willing and able to do these custom in-kind redemptions. This requires systems and expertise, as well as managing in an asset class where it is feasible. Custom in-kind redemptions tend to be less prevalent among international portfolios (especially in emerging markets) and fixed-income securities (especially in lower-rated bonds and municipal bonds).

 

Expenses

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The Backstory. Many of the first ETFs were passively-managed, attempting to replicate a benchmark index, making it relatively easy to deliver cost savings to investors. However, many ETFs created in recent years offer active management, attempting to outperform the benchmark index, which often requires a greater number of investment professionals, data sources, and software applications, which have costs. Expense ratios are a common way to measure the cost of a mutual fund or ETF on an ongoing, annual basis.

 

The Benefit. Active ETFs, on average, tend to have lower expense ratios than active mutual funds. Table 1 shows the number of active ETFs and mutual funds in certain major asset classes, along with their average expense ratios. For example, the average expense ratio of large value active ETFs is 28 basis points (0.28%) cheaper than the average expense ratio of active large value mutual funds (measured using institutional share classes). The cost savings are slighter for broad fixed-income investments, where active ETFs are 13 basis points cheaper than active mutual funds, on average.

 

The Number of Active ETFs, Active Mutual Funds, and Related Expense Ratios

 

The Burden. It is also true that not every active ETF is cheaper than a comparable mutual fund. In our sample of 7 major asset classes, we found 20 out of 178 active ETFs to have higher expense ratios than the average active mutual fund (roughly 11% of instances). When considering an ETF, we would caution against assuming it is cost-effective simply because it is an ETF. Fortunately, the expense ratios of mutual funds and ETFs can be readily found in their prospectuses. The relatively sparse number of active ETFs in the small cap asset class is also noteworthy. Many asset managers have expressed reluctance to offer small cap active ETFs due to liquidity reasons and the inability to close an ETF when assets become too large to stay invested in small companies.

 

Intraday Trading on an Exchange

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The Backstory. Mutual funds are priced once per day, after market close, based on the value of their underlying holdings, referred to as Net Asset Value (NAV). Investors can place orders during the trading day, but the orders are executed using the closing NAV price that is not yet known to the investor.

 

The Benefit. An ETF can be purchased during the trading day, giving the investor a better idea of the price they will be paying for shares. Additionally, the actions of APs in creating and redeeming shares often keeps transactions (and their related costs) outside of the fund. By contrast, when investors enter or exit a mutual fund, the fund’s existing shareholders bear the transaction costs that occur when the fund manager buys or sells securities to accommodate the in- or out-flows.

 

The Burden. The trading costs do not simply go away. Rather, trading costs are shifted to the investor who is buying or selling ETF shares, which they do on an exchange, similar to buying an individual stock. This gives rise to some important considerations of owning an ETF that generally do not apply to mutual funds:

 

• Bid-ask spread. Dealers in securities make money buying at the (lower) bid price and selling at the (higher) ask price. The typical investor often pays a price closer to the ask price. Therefore, the spread in price can be viewed as a cost to the investor. This is relevant for buyers of ETFs, because they will generally pay a little more to buy an ETF than they would to sell it.

• Premium/discount. Whereas mutual funds are bought and sold at their Net Asset Value (NAV), which is determined after market close, ETFs are bought and sold on exchanges throughout the trading day. Therefore, an ETF can sometimes cost more than the value of its underlying securities, which is referred to as a premium. They may also sometimes trade at a discount.

• The cost of any brokerage commissions, if applicable.

• When buying ETFs, investors may want to consider placing limit orders rather than market orders so that the purchase price of the ETF stays within their comfort level.

 

Partnering with LPL Research

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To pursue the benefits of active ETFs, there is an associated burden of monitoring that the ETFs are doing what investors expect. When you partner with LPL Research, we can help you bear the burden of monitoring, while you gain access to the potential benefits. Below are just a sampling of key items we monitor among the active ETFs under our coverage.

 

• Total Cost of Ownership. This is an estimate of annual costs that include fund expenses, securities lending, bid/ask spreads, and taxes on distributions.

• We seek to understand which ETFs are actively attempting to minimize taxable events and which are not. Like mutual funds, ETFs may periodically distribute capital gains distributions to investors, which may be taxable events for investors. ETFs that are using custom, in-kind baskets as part of their process may be more likely to minimize capital gains distributions.

• When necessary, we engage with the Capital Markets Teams of the ETF provider to understand what they may be doing to promote narrow spreads and tight tracking to the NAV.

 

• Important Disclosures
• This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
• Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk.
• Indexes are unmanaged and cannot be invested into directly. Index performance is not indicative of the performance of any investment and does not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
• This material was prepared by LPL Financial, LLC. All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
• Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.
• Asset Class Disclosures –
• International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
• Bonds are subject to market and interest rate risk if sold prior to maturity.
• Municipal bonds are subject and market and interest rate risk and potentially capital gains tax if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply.
• Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. They may be subject to a call features.
• Alternative investments may not be suitable for all investors and involve special risks such as leveraging the investment, potential adverse market forces, regulatory changes and potentially illiquidity. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.
• Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.
• High yield/junk bonds (grade BB or below) are below investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
• Precious metal investing involves greater fluctuation and potential for losses.
• The fast price swings of commodities will result in significant volatility in an investor's holdings.
• This research material has been prepared by LPL Financial LLC.
• Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value
• For Public Use – Tracking: #801997

 

Contact us directly should you have questions about this topic.