One thing that makes ETFs desirable is their transparency, which means the investor can see a full picture of costs. But because of that feature, some investors may wrongly believe that transactions on ETFs, which often involve paying a spread, are costlier than mutual-fund transactions, which occur at a fund’s net asset value (NAV).
“Investors of mutual funds like the fact that the funds transact at net asset value (NAV), because they think they’re not paying the spread seen on-screen for ETFs,” Michael Barrer, senior associate of Capital Markets at WisdomTree, wrote in a recent note. “In fact, mutual funds, just like ETFs, are wrappers around baskets of securities. And just because a mutual fund transaction occurred at NAV, does not mean it was FREE!”
Barrer explained that since ETFs are traded on an exchange, the spread cost is fully transparent to investors. The full cost spread of an ETF — known in the industry as the “arbitrage band” — is composed of the spread of every underlying stock in the basket, transaction costs, and a small fee to cover the market maker’s service.
In contrast, mutual-fund holdings aren’t transparent, and the costs aren’t baked into the NAV. An investor who purchases a mutual fund with the same underlying portfolio would pay a certain amount of money and receive the equivalent NAV of the mutual fund in return.
“Besides the value of the holdings, a mutual fund’s NAV is reduced by the same kinds of costs that investors see in the real-time bid/offer spreads of ETFs,” Barrer said. “The spread or costs for a mutual fund may not be visible, but that doesn’t mean they don’t exist.”
When an ETF reaches critical mass and begins to trade more frequently, he continued, it can trade inside its arbitrage band, which is less than the cost to transact in the underlying portfolio. Once an ETF becomes liquid to the point that natural buyers and sellers get paired with no need for transactions in its underlying portfolio, investors can save on transaction costs.
“Mutual funds never have this opportunity, as the portfolio manager always needs to buy or sell assets when money comes into or out of the fund,” Barrer said.
Finally, he said, every transaction cost in an ETF is independently borne by the investor that makes the transaction. This is because the creation and redemption process in ETFs allows for an authorized participant to transfer shares of the underlying portfolio in kind in exchange for ETF shares.
“In a mutual fund, however, all trading of the underlying securities occurs inside the portfolio and every trade cost is shared by all investors regardless of their percentage ownership in the fund,” Barrer noted.
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