Zaks Investment Advisory Service

Exchange-Traded Funds: A Little More About Their Advantages and Shortcoming

Last time, I started telling you about exchange-traded funds (ETFs). I mentioned that an ETF is a type of index fund whose shares are traded on the stock exchange. I also said that ETFs allow people to execute investment strategies that were previously only available to professionals.

Another advantage of ETFs is their low expenses. We once devoted an entire program to fund fees and expenses charged for the provided services. The annual expenses of any fund are determined by the so-called expense ratio. In essence, this ratio gives you an idea about what portion of the fund’s assets is spent on expenses. ETFs are distinguished by exceptionally low expense ratios. For example, we could compare the expenses of ETFs and similar index mutual funds that reflect the S&P 500 index. The ticker of one such ETF is SPY. SPY’s expense ratio is 0.08 percent. For comparison, the expense ratio of a similar mutual fund run by Charles Schwab (its ticker is SWPIX) is 0.36 percent, i.e. four-and-a-half times higher. The S&P 500 is a simple and popular type of index fund, so competition between the funds leads to their expense ratios staying relatively low. But when matters touch more specialized funds, the difference in expense ratios starts getting even larger.

Suppose that our investor decided to place some money in the shares of a few Russian companies. There are several strategies at his disposal. For example, he could buy so-called American Depository Receipts, or ADRs, i.e. securities that are equivalents of foreign shares, but which at the same time are traded on the US exchanges. Yet there are only a limited number of such ADRs: many large Russian companies are not represented on the U.S. exchanges. Plus, being an experienced person, our investor would like to diversify his portfolio. In this case, he is left with only two alternatives: to either purchase a Templeton closed-end fund, which is called just that, the Templeton Russia Fund (its ticker is TRF), or to buy an ETF, which is called the Russia ETF. Its ticker is RSX. The Templeton fund, despite its name, does not only buy Russian shares but also those of a few East European companies. This is not a very serious problem because most of its assets are still made up of Russian companies. Nevertheless, I would like to point this out because an ETF that invests exclusively in Russian companies allows you to follow a particular investment strategy more precisely. The greater difference between the two funds is their expense ratio. At Templeton Russia Fund, it stands at 1.84 percent. That of RSX, at the moment, is 0.69 percent, i.e. the ETF’s expenses are 1.15 percent lower than those of the closed-end fund.

By the way, an interesting story recently happened to the Templeton Russia Fund. You may remember that when we talked about closed-end funds, we mentioned that their price is determined on the exchange, and that sometimes this exchange price fairly significantly differs from its net asset value (NAV), i.e. the price of securities making up the fund’s assets on a per-share basis. Before the issue of a similar ETF, the exchange price of the Russian closed-end fund usually exceeded its NAV, i.e. it traded at a premium. Half a year ago, this premium was almost 20 percent. But once a very efficient alternative to this closed-end fund appeared in the shape of an ETF, this premium started to shrink, and now the closed-end fund’s shares are traded at just about their NAV value. Russian shares have gone up about 17 percent over the past six months, and the ETF that tracks these shares also gained 17 percent. The shares making up the closed-end fund also gained about the same, i.e. the closed-end fund’s NAV also went up by about 17 percent. But the market price of the closed-end fund shares fell because the 20-percent premium fell to almost zero. As a result, the closed-end fund shares have lost three percent over the past half-year, while the shares of a similar ETF have gained 17 percent! You could imagine that Templeton’s investors are quite disappointed.

Another ETF advantage is that its shares are traded in real time: you pay for them as much as they cost at that very moment. As I have mentioned, when you buy a mutual fund, you do not really know how much it will cost: its price is only determined at the end of the trading day on the basis of how much its net asset value is worth at that time. ETFs, on the other hand, allow you to assess the price of the shares ahead of time. Overall, ETF shares are almost completely identical to regular stock shares. For example, you could “short sale” the shares. Some investors employ the “short sale” mechanism when they expect share prices to fall.

I must note one disadvantage of ETFs compared to mutual funds. Usually, after you buy a certain number of shares, mutual funds offer you an opportunity to buy additional shares in any amounts without any extra expenses. In other words, for example, having once invested $5,000 in a mutual fund, you could add another $100 on a monthly basis. On other hand, each time you buy an ETF, you have to pay for broker’s fees. These days, broker’s services do not cost much, but if you plan to invest another $100 a month, then these things start adding up; you’d be probably better off buying a mutual fund.

As I have mentioned, one of the advantages of ETFs is that they have allow a regular investor to apply strategies that were previously inaccessible to him. For example, they simplified investments in foreign company shares. International investments are a very interesting subject in general. And this is what we will talk about next time.

But with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.