Why John Locke Would Have Loved ETFs

The eternal promise of capitalism is that it drives the living condition of mankind perpetually higher by spurring innovation demanded by a sovereign consumer.  Exchange-traded funds are a manifestation of the Lockean Natural Law doctrine in the marketplace for investment products.

One of the greatest benefits accrued to the individual investor from ETFs is cost savings.  Savings in ETFs occur in more ways than just the stated expense ratio of a fund.  Investors are spared the heavy burden of internal fund trade commissions, principal markups on internal trades, and capital gain taxes on distributions that frequently do not represent actual investment returns earned.

Many investors and even some financial advisors think that a mutual fund’s stated “expense ratio” is the total cost to an investor of owning a mutual fund.  While the front end sale charge or “load” may be all but dead, and the dreaded 12b-1 fee on life support, hefty trading costs are still very much an important consideration.  Unfortunately they are rarely understood.

When money is deposited into an old style mutual fund and the fund manager purchases stocks the fund pays commissions.  The same is true when a fund manager sells stocks to meet redemptions.  Additionally, the fund incurs commissions whenever it buys and sells in the normal course of management.   Mutual fund companies are not required to disclose in their prospect, the amount of commissions paid.  Instead this information is disclosed in a document called the Statement of Additional Information.  There is no requirement that a fund company provide this information to investors at the point of sale, only that it should be available on request.

ETFs also must disclose commissions paid in their Statement of Additional Information (SAI).  However, because ETF shares are created “in kind” rather than by monetary contribution, the fund itself incurs very little in the way of commission expenses.  Further, because the holdings within an index tracking ETF change very little in the course of the year, any actual commissions paid are generally very small.  And of course, commissions come out of your pocket and reduce your investment returns.

Comparing the commission expenses of some ETFs to some well known old style mutual funds provides clarity.

The commissions a mutual fund pays for executing a stock transaction don’t fully reflect the total cost of transacting in that security.  There are bid/ask spreads to be dealt with and the broker executing the trade for the fund may be acting in a “principal” capacity wherein they may mark the price of the security up (when you buy) or down (when you sell).  The amount of any markup or markdown is not included in the commission column above.

Some mutual fund companies own an affiliated broker/dealer where they execute many of the trades for their funds.  Fidelity (FMR), for example discloses in its SAI that it places transaction with affiliates of Fidelity.  Fidelity further discloses that “FMR may allocate brokerage transactions to brokers who have entered into arrangements with FMR under which the broker, using a predetermined methodology, rebates a portion of the compensation paid by a fund to offset that fund’s expenses, which may be paid to FMR or its affiliates.”

Index based ETFs have very little internal trading during a year because of the previously described share creation process but also because of their index mimicking strategies.  Old style funds are generally more actively traded and if successful will experience “realized” capital gains.  Realized capital gains must be distributed annually to shareholders by law.  These gains are fully taxable in the year received and represent another significant expense to shareholders.