Exchange traded funds feed many

by Stephen Butler

"Where are the customers' yachts" is the time-worn cliche describing a basic condition in the financial services industry. Namely, the more financial intermediaries make, the less their customers make. The latest expression of this phenomenon could easily be the invention of exchange traded funds known as ETFs.
A conventional mutual fund takes in money from people like you and me and invests that money in a collection of public companies. At the end of each day, the entire fund portfolio is valued based upon closing share prices, and our proportionate share of the entire mutual fund is calculated. If we called to say we wanted to sell our mutual fund holdings, the fund would wait until the end of the day to determine the account value and then send us a check using some of the cash they maintained for the purpose of meeting our "redemption request."

ETFs are different. They are effectively stocks that track what would otherwise be an index or cross section of many companies. They are valued throughout the day just like any individual stock. When you decide you want to invest in some shares of an ETF, you are buying them from someone who wants to sell. You pay a brokerage commission, and although you're a stockholder in the ETF, you also pay an ongoing annual expense ratio as you would with a regular fund.

When we buy a conventional mutual fund, the fund spreads our money out over the stocks the fund owns. Our share price will be the end-of-day asset value of all the companies owned by the fund divided by number of outstanding fund shares.

By comparison, when we want to buy an ETF, the so-called specialists or market-makers on the floor of the stock exchange generate "creation units" which are baskets of stocks reflecting the particular index of the ETF we want to buy. Then these "creation units" are put up for sale. If it just so happens that there are enough existing shares for sale to meet the demand for purchases, the creation units will not be necessary, but so far, the demand has been so great that creation units have been required.

When buying or selling an ETF share, the price is based on supply and demand, at the moment of transaction, for that share. Therefore, the transaction price can be higher or lower than the actual cumulative value of all the company stocks owned by the fund at that moment. This is referred to as a "market inefficiency," and skillful investors can use what is called "arbitrage" to buy and sell over short periods to make money in small incremental amounts.

Over time, it can add up to big money. On one day, for instance, the trading price for Vanguard's Large Cap Index ranged from $62.92 up to $63.66 -- more than 1 percent difference. When an ETF is determined to be a good value based on the cumulative prices of the stocks it owns, the smart investor knows that it will "revert to the norm" soon enough with a price that rises to reflect the cumulative value of the underlying stocks.

ETFs can be bought "on margin" which means that you can borrow money to buy them. You can also sell them short, which means that you can profit when the price goes down. They can also be bought in small amounts, which is not always true with some index funds that have minimum initial purchase requirements.

The main advantage of ETFs, once over the commission hurdle, is that they offer a reduced annual expense ratio. An investor share of Vanguard's traditional, total-market index fund charges 0.19 percent per year. The ETF equivalent charges only 0.07 percent ($70 per year on $100,000).

Out there in the rest of the financial world, it's a different picture.

The average index fund charges 0.70 percent and the average ETF charges 0.40 percent. So, "Where are the customers' yachts?" If the definition of an index fund is one that is "passively managed" (which means no active stock picking), then who gets to keep all that extra money?

If Vanguard can keep track of a total stock market index for 0.07 percent, that should tell us something about where the money for those yachts is coming from. ETF held up to a brokerage firm's mirror reads "FTE -- Feeding Trough for Everyone."

According to John Bogle, the founder of Vanguard, ETFs have generated a 16,000 percent profit, in at least a few cases, for those who invested the seed capital to get them off the ground.

The problem that Bogle sees is that ETFs, apart from being a feeding trough for the brokerage industry, also set the stage for investors becoming their own worst enemies. The ability to day-trade an index cuts against the grain of what index funds were all about in the first place. The theory of an index fund investment is that a broad cross section of stocks, if left alone, will outperform 85 percent of all attempts to manage money actively because active management costs too much.

Now, we are introducing hundreds of index funds that are so specific that they might just as well be individual stocks. There is an index fund, for example, that offers a cross section of just those health care companies focused on cancer cures.

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