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Passive Indexing has Evolved

Because the mutual fund has been around for many decades, more people understand this structure of investment than the exchange traded fund (ETF), particularly because most have been exposed to the mutual fund within their 401(k). With passive indexing, there is more to consider, and we think it’s worthwhile to explore the ETF for passive indexing.  Here’s a bit more about the ETF that you should probably know.

Passive indexing has evolved significantly. There has been a steady inflow into low cost indexes in the past decade vs. actively managed mutual funds. In the ETF (exchange traded fund) world, there’s an index created for just about everything: cyber security (HACK), restaurants (MENU), emerging markets/internet & ecommerce (EMQQ), gender diversity in senior leadership positions (SHE), hedge funds, leveraged, alternatively weighted, and the list goes on.

Index investing may be considered passive, but buyer beware. There is so much choice out there. You might want to do a bit more research before plugging your retirement account into that passive fund.

For example, take the S&P 500 index. Did you know that there are more than 50 S&P 500 Index funds to choose from?  While it’s often nice to have choice, do you know how to choose? Consumer Reports has a handy list to help you distinguish among the choices:

  1. Examine the fees.
  2. Consider the fund’s tracking error.
  3. Examine the fund’s tax efficiency.
  4. Consider the fund’s parent company.

Within the ETF, the costs and tax-efficiency of the ETF structure differs from the mutual fund. This is not to say that one shouldn’t consider investing in mutual funds. However, when passively investing, ETFs offer a few more things to consider.

Costs/Fees of an ETF – consider the explicit as well as the implicit costs of owning the ETF.

When we think of costs, we naturally think of the funds internal expense ratio, in other words, the explicit cost associated with that fund. (As a refresher, the internal expense ratio is the cost built into the fund to pay for expenses like portfolio management, trading, operational costs and index licensing.) What many often don’t think about are the implicit costs.

Implicit costs are things like the bid/ask spread, tracking error, volume of the ETF and the liquidity of the underlying assets that make-up the ETF.

The bid/ask spread is the difference between the price an investor could sell a security or buy a security at a given moment in time.

Why is this important? Because one fund may have a wider bid/ask spread than another therefore adding to the all-in cost of ownership.

Tracking error can be an implicit cost when there is underperformance. Tracking error is monitoring how closely the performance of the portfolio manager is tracking the performance of the underlying index.

Why is this important? If a fund is underperforming, there is the implicit cost of having had the opportunity to invest in a fund with less tracking error than the one purchased. Most often you’ll see a higher tracking error exhibit a lesser return than the index the fund is tracking.

The volume of an ETF as well as the volume of the underlying asset that the ETF owns may affect the spread. The spread is the difference between a funds bid and ask. It can also be viewed as the difference between the price at which an ETF is trading and the ETF’s net asset value (NAV). To further clarify, the bid is the price an investor can sell a share and the ask is the price an investor can buy a share. In the case of volume, more is less, meaning that generally, the more or higher the volume of an ETF the smaller the bid/ask ratio. This typically means the investor buying or selling has a cost savings vs. a lower volume ETF that has a wider or larger bid/ask spread.

Liquidity…As a rule the less liquid the underlying market is, the higher the cost of ownership.

Tax efficiency of the ETF – the exchange-traded fund can be very tax efficient. It is inherent in the structural differences of the ETF vs. the mutual fund. ETF issuers are allowed to create and redeem shares of their ETF in-kind. For instance… if there are more sells than buys of an ETF on a given day, shares of that ETF can be redeemed by an authorized participant (AP) to the ETF issuer in exchange for the underlying holdings of that ETF. Hang in there, this is a good one! Therefore, the transaction is cashless and does not trigger a taxable event and is therefore more tax-efficient. Keep in mind this is a general rule of thumb and as with all things, there are exceptions to the rule.

So, if you’re thinking more about passive investing, keep in mind, you’ll want to be “active” with your research and get a better understanding of that passive investment before you just plug it in and go.

Important Note: The views expressed in this post are as of the date of the posting and are subject to change based on market and other conditions. This post contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

Please note that nothing in this post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and should not be taken to be, investment, accounting, tax or legal advice. If you would like investment, accounting, tax or legal advice, you should consult with your own financial advisors, accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Lenity Financial, Inc. unless a client service agreement is in place.