Understanding ETFs
A common recommendation these days for investing is periodical purchases of a broad-indexed ETF, such as the Vanguard FTSE All-World UCITS ETF (VWRD). This strategy is also a component of my savings. However, I got increasingly uncomfortable as time passed with my limited understanding of ETFs. Therefore, I wanted to understand more and understand the following questions:
- What is the main difference between mutual funds and ETFs?
- Which risks do I take on when owning an ETF, especially when compared to a mutual fund?
- What happens when a mutual fund or an ETF provider goes bankrupt?
- When is an ETF the right choice and when should I invest in mutual funds?
My goal is to answer these questions. I will not get into questions that are broker-specific or questions relating to tax, even though this can be worth thinking about. For example, ETFs often use an in-kind creation and redemption process, which can often be more tax efficient by avoiding capital gains. Finally, the goal is to understand
Creating and Redemption of ETF shares
To understand ETFs it is important to understand the creation and redemption of ETF shares and how the process ensures that the price of an ETF share reflect the underlying basket of assets that the ETF is tracking, e.g., the S&P 500. ETF shares are created or redeemed when authorised participants, i.e., big banks and other financial institutions, trades with the ETF sponsor, e.g., Vanguard. If the AP buys an ETF share then an ETF share is created by the sponsor. The AP might pay in-kind, i.e., with the basket of assets that the EFT tracks. The AP will do this if there is an arbitrage opportunity, i.e., if the ETF price in the secondary market is higher than the net-asset value1 (NAV) of the basket. The AP can then buy the basket of stocks for 100 EUR and get an ETF share that is valued at, say, 101 EUR in the secondary market. Similarly, an AP will redeem shares if the ETF shares are worth less than the NAV of the basket of stocks. Small investors, like myself, can only trade in the secondary market. We rely on the creation and redemption process to ensure that the tracking difference is small.
Different Risks between ETFs and Mutual Funds
In this section, I'll look into the some risks that differ between mutual funds and ETFs. I will not go into risks they share, such as market risk. The ETF prospectus gives a detailed run-through of all thinkable risks, e.g., Eurozone Crisis Risk and specific Chinese risks.
Liquidity Risk
The section above already gives us an idea of one risk that is different for mutual funds and ETFs. Namely, an investor like myself trades ETFs in the secondary market. Therefore, I take on liquidity risk. If no authorised participant or just another buyer is willing to buy ETF shares I cannot sell, or I have to sell below the NAV. This risk is not there for a normal mutual fund. However, for a mutual fund one runs a more typical bank risk, i.e., that the fund provider doesn't have cash on hand to liquidate my holdings. This could also be due to illiquid markets.
Counter-party Risk
What happens when an ETF sponsor or a mutual fund provider goes bankrupt? In both cases, they go through a liquidation phase. The assets underlying the fund or the ETF are protected. Investors are also first in line, before debtors. In other words, in most cases you will be made whole. This does not of course include outright scams where the rules haven't been followed.
Tracking Difference Risk
One risk or metric to consider when investing in ETfs or mutual funds is the tracking difference risk. Let's use VWRD as an example. The index is a big one so the ETF uses a sampling strategy to try to replicate the index performance, instead of actually owning every stock in the index. There are several reasons to do this, but the main two are costs and illiquid stocks. The costs relate to the cost of actually rebalancing and aqcuiring every stock in a huge index, especially a global one like FTSE. The illiquidity of certain stocks relate to the fact that it can be hard to go in and out without significantly moving the price to the fund's disadvantage. Additionally, there are many other risks for global indexes that relates to the different countries' laws and regulations, but they are out of scope.
The risk exists for both ETFs and mutual funds, but it behaves differently. An ETF is more flexible due to the creation and redemption process described above so it is repriced continually. A mutual fund does a daily calculation of NAV and rebalances accordingly. In addition, inflows and outflows can lead to larger tracking errors due to timing and execution. The funds also engage in things like securities lending to try and make up for operational costs and to minimize the tracking error. These practices come with their own risks2.
Example: Vanguard FTSE ETF versus Mutual Fund
Vanguard provides an ETF an a mutual fund for the same index. They also provide a comparison tool where we can glean the following key facts:
| VT (ETF) | VTWAV (Mutual Fund) | |
|---|---|---|
| Expense ratio | 0.07% | 0.10% |
| YTD | 9.59% | 9.53% |
| 3-year | 7.06% | 7.04% |
The differences are small and it is easy to see that in terms of costs and performance it all depends on your broker and taxation. Interestingly, the VTWAX was only created in 2019.
Conclusion
In the end, investing in an all-world index ETF is a bet on the world as a whole, even if the world in this case means roughly 60% US and only 3% China. The breakdown by country can be easily be found online, e.g., in the annual report. The mutual fund is a simpler mechanism and might be seen as a more robust than an ETF, as the ETF pricing mechanism and trading depends on a liquid market and a functioning market of authorized participants.
Footnotes:
The net asset value is essentially the difference between the assets and liabilities divided by the number of outstanding shares. For ETFs and mutual funds it should be very close to the book value of the shares the fund holds.
Such as counter-party risk and undercollateralization. Imagine the scenario of a short-positioned borrower. If a short squeeze occurs, the borrower might default and the loan might be under-collateralized (due to the big price increase stemming from the short squeeze). In other words, the ETF must repurchase at a price higher than the collateral and loses the difference.