Weighing the advantages of an all-ETF portfolio

There's a natural progression in the way the public responds to innovation. Something that first seems like a mere novelty becomes an interesting new niche, then a great idea and then, "How did we ever get along without this?"

In financial services, exchange-traded funds are somewhere around the third or fourth stage, between new niche and great idea. ETFs attracted more net investment last year ($239 billion) than did mutual funds ($225 billion), according to data from Morningstar. Five years earlier the net inflow into mutual funds was more than triple the net amount invested in ETFs.

NYSE New York Stock Exchange traders markets
Brendan McDermid | Reuters

In the last five years, the public's affinity for ETFs raised assets under ETF management by 152 percent, to $2 trillion, up from $793 billion. Mutual fund assets only rose 53 percent during the same period.

Faster and cheaper information system infrastructure has helped the growth of ETFs. In my view, ETF portfolios will be the inevitable default for investors in the years to come because they are lower cost, more transparent and offer greater liquidity and tax advantages than mutual funds. Already, the increasing number of assets invested with automated investing services, which use all-ETF portfolios, underscores this shift.

Lower cost

By passively and systematically tracking an index, ETFs are far cheaper to run than most actively managed mutual funds that employ portfolio managers and analysts to select securities. That research costs money, and so does the frequent trading that's common in such funds—they call it "active management" for a reason—not to mention the buying and selling of fund shares themselves, transactions that always involve the fund provider.

More transparent

ETFs also feature greater transparency. Their underlying portfolios change more rarely because the indexes that they're based on generally maintain stable lists of components. The high turnover of many mutual funds and the fact that their holdings are reported only four times a year can make it difficult for shareholders to know exactly what they're holding.

It's not just the specific securities that can keep mutual fund investors in the dark. The broad nature of the fund itself can become obscured by what's called "style drift." Say growth is outperforming value; the managers of value funds, consciously or not, may start tilting toward more growth-oriented stocks.

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Depending on what else they own, shareholders may become overweight in growth stocks and not even know it. By contrast, a value-stock ETF will hold value stocks no matter what.

ETFs are more transparent in another sense. The very low expenses and commoditized nature of ETFs make commissions and "kickbacks" to brokers or retirement-plan sponsors impractical. So if an ETF is recommended by an advisor or made available by a broker or retirement-plan sponsor, it's likely to be an unbiased recommendation.

Tax efficiency

ETFs provide investors the opportunity to be far more tax-efficient than mutual funds in several ways.

Both ETFs and mutual funds must distribute any net capital gains incurred inside the fund on an annual basis. However, two factors favor ETFs on this point, causing them to distribute far less on average. The first is a function of the tax efficiency of passive investing, generally. Index-tracking ETFs simply have less internal buy-and-sell churn, as opposed to active mutual funds. Less selling means fewer realized capital gains.

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The second factor is more technical and disadvantages even a passive index-tracking mutual fund. If mutual fund investors want to redeem shares, they must do so directly through the fund, which has to sell internal holdings to finance the redemption. Any gains realized in these sales must be distributed pro rata to all investors, not just the ones redeeming their shares.

So you may owe taxes even if you haven't sold any shares that year. On the other hand, the way you liquidate an ETF position is by selling it on the open market, without affecting other shareholders. With an ETF, another shareholder's sale will never realize taxable gains for you.

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ETFs are also better suited for automated tax-loss harvesting, because they allow investors to take advantage of temporary market dips. At its most basic level, tax-loss harvesting is selling a security that has experienced a loss—and then immediately buying a correlated asset (i.e., one that provides similar exposure) to replace it. The strategy allows the investor to realize a valuable loss, which can be used to reduce or defer a tax liability, while keeping the portfolio balanced at the desired allocation.

Mutual funds can only be bought or sold once a day, using the end-of-day price. ETFs are market-traded, and they can be bought or sold at whatever the market price happens to be at that moment. Normally, this would be of little significance to a long-term investor.

However, a harvesting algorithm that monitors your passive ETF portfolio throughout the day can capitalize on a temporary midday dip in the asset price. The asset may have recovered by market close, and an investor holding an equivalent mutual fund would not have the same opportunity to realize a tax benefit.

Greater liquidity

The intraday trading also allows ETF shareholders to benefit from greater liquidity, as compared to once-a-day mutual funds. This liquidity results in greater volume, reducing costs and ensuring more accurate pricing.

The success of ETFs has done away with a drawback often attributed to them in the early days. Then, ETFs were believed to be limited to plain-vanilla asset classes, such as large American stocks, while mutual funds enjoyed a reputation for going where no investor, at least no mainstream American investor, had gone before, including small emerging markets.

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The thinking was that successful investing in the developing world depended on active portfolio managers with intimate knowledge of local activity, but by now, whatever edge there may have been has been reduced substantially. Emerging markets are broader and deeper, so indexes can now provide a better reflection of local economies, making passively managed ETFs a viable strategy.

Today there is a growing number of ETFs available for a wide range of interests, from regional and single-country ETFs in emerging and mature markets to ETFs in foreign niches. There are niche ETFs for specific commodities, and soon even for bitcoin. However, it's important to understand that investing in an ETF still exposes you to the risk of the ETF's holdings—and those holdings can still be poor investments.

"Even as ETFs are more cost-effective than mutual funds overall, investors should still evaluate each fund's expense ratio, liquidity and the role it will play in a diversified portfolio."

Innovation in ETFs has created opportunities for innovation in financial planning, too, including the low-cost all-ETF portfolios that have become popular with automated investing services.

Even as ETFs are more cost-effective than mutual funds overall, investors should still evaluate each fund's expense ratio, liquidity and the role it will play in a diversified portfolio. There are other ways to invest successfully, of course, but relying on an all-ETF portfolio offers more potential to turn a small but consistent edge—reduced expenses—into a substantial increase in wealth over the long haul.