Mark Riepe: Welcome to Financial Decoder, an original podcast from Charles Schwab. I’m your host, Mark Riepe. On this podcast, we break down the cognitive and emotional biases that influence your financial decisions and offer strategies to help mitigate those biases and help improve your financial outcomes.
If you’ve ever shopped for a new car, you know how car dealers love to talk about the car’s specifications, or specs. It’s easy to get caught up in the operational specs—the leather interior, the backup camera, lane control, blind spot sensor, the number of air bags and so on. And all of that is important, but if you’re also interested in fuel economy, horsepower and torque, you’re going to need to pay attention to the performance specs. And depending on how you’re going to use the vehicle, you will want to know the construction specs, things like the total weight, how high it is, how long and how much ground clearance it has.
Things are similar in financial services, where new products are introduced all the time. You have to really understand the specs to know which ones are right for you. Today, we’re going to dig into the specs on one product that’s increased in popularity and one we get questions about all the time, and that’s the exchange-traded fund, or ETF for short.
You’re probably familiar with ETFs. They’re not especially new. The first one launched in 1993, but in recent years, their growth has accelerated rapidly. By year-end 2017, there were over $3 trillion invested in them in the United States. An ETF is a collection of securities, usually stocks or bonds, that can be bought and sold as a complete basket. Think of ETFs as similar to mutual funds, but they trade throughout the day, whereas mutual funds trade only once per day. In this episode, we’re going to evaluate which specs really matter when shopping for ETFs, and we’ll point out some of the blind spots that may keep you from making the best decisions when it comes to picking the right products for you.
One classic decision-making error is narrow framing. By that I mean the excessive focus on one aspect of a decision when taking a broader view or frame might lead to a different decision. Airline tickets are a nice example of this principle in action. The ticket price matters a lot to people when choosing flights, and airlines aggressively compete on price. The ticket price becomes the decision frame. But actually, the ticket price is just one component, albeit an important one, of the cost of getting from where you are to where you need to go. Maybe the cheapest flight is to an airport that’s inconveniently located, and the extra cost of the transportation from that airport to your final destination eats up what you save by buying the cheaper ticket to the inconvenient airport. Maybe the cheap ticket comes with extra fees, such as baggage fees, or long layovers that mean you end up spending more on meals, and that ultimately increase the total cost you pay for the flight. The point I’m making is that if money matters to you, broaden your decision frame to be the total cost of transportation and not just the cost of the ticket.
There are some similarities between that example and ETFs. The operating expense ratio, or OER, for short, is the fee many ETFs advertise the most, and it’s really important, but like the plane ticket example, it isn’t the only factor when it comes to total cost. There are trading commissions to consider and also the bid-ask spread, which we’ll get to in a minute. What’s especially interesting about ETFs is that the importance of each cost may vary depending on your approach to investing.
Joining me now to help explain ETFs in more detail is Michael Iachini. Michael is a vice president at Charles Schwab Investment Advisory, and he leads their ETF research effort. He’s written a number of articles on ETFs that you can find on Schwab.com, and his team prepares the Schwab ETF Select List. Michael also contributes to Schwab’s research into mutual funds and separately managed accounts. Welcome, Michael.
Michael Iachini: I’m happy to be on the show, Mark.
Mark: Earlier I gave a quick and dirty definition of an ETF, but I think it’s more helpful to understand ETFs by comparing them to mutual funds. So in what way are ETFs and mutual funds the same?
Michael: Sure. So ETFs and mutual funds are both ways of buying a whole portfolio of lots of different stocks or bonds or other investments managed by some professional, all with a single trade. They both give you more diversification than, like, buying single stocks, for instance.
Mark: So in what way are they different?
Michael: The big difference is the way you trade them. ETFs, they trade like stocks throughout the day, with a price that moves up and down in real time. Mutual funds, on the other hand, they only trade once per day, and that’s going to be after the market closes. All investors will get whatever the price for the mutual fund happens to be that day.
Mark: So I kicked off the episode by mentioning that ETFs have become enormously popular. What’s driving that popularity?
Michael: The biggest reason that ETFs have become so popular is cost. ETFs tend to have some of the lowest annual fees out there when it comes to getting some kind of professional management. And ETFs also provide access to lots of assets that can be hard to own, things like commodities or foreign bonds.
Mark: Let’s talk more about costs. It makes sense that investors, when framing the decision about which ETF to select, that they should pay attention to costs, but if they just focus on the expense ratio of an ETF, that frame may be too narrow. I think they need to broaden their decision frame to include the all-in costs of making that investment. Does that make sense?
Mark: Let’s run through some of those costs, and what I’d like you to do is define the cost, identify how big it is relative to other costs, and then tell me what kind of investor the cost most effects. Does that make sense?
Michael: Yeah, let’s do it.
Mark: OK, let’s start with the OER, or the operating expense ratio.
Michael: All right. So that expense ratio, that’s the percentage of your money that the ETF manager is going to spend over the course of the year to cover their manager’s costs of running the fund. This is going to be things like the manager’s salary, index licensing, computer hardware, software, legal fees and so on. This money, it comes out of the ETF a little bit each day, and it covers their costs throughout that whole year. Expense ratio is generally the biggest part of the cost for most ETFs, and it particularly affects long-term investors in the fund more than people who are trading it really actively.
Mark: So the industry is pretty competitive, the ETF industry, I mean. The different companies that offer them, they’re paying close attention to what other competitors are charging. So does that cause fee compression?
Michael: Oh, yeah, absolutely. So if you look back 10 years, look at the end of 2008 and then to 2018, the average expense for a dollar invested in an ETF has dropped by about a third. Back in 2008, it was about .32%, these days it’s more like .21%.
Mark: Right. So that’s very investor-friendly. That’s a fantastic development. Nice to know that competition works.
I think there’s something called the availability heuristic that I think is really important to people to understand. The essence of the heuristic is that when you need to make a decision, you use evidence to help you decide, and that evidence that’s most available, that’s going to be the evidence that you give the most credence to. That makes sense a lot of the time, but what can lead people astray is paying too much attention to that kind of evidence when instead they should be looking deeper. And I think that could be happening with ETFs. There’s so much focus on OERs and perhaps not enough focus on other aspects of the ETF selection decision. So what other things should investors be paying attention to?
Michael: Well, other things being equal, going with a low-expense-ratio ETF is better than going with a high-expense-ratio ETF. But, you know, other things aren’t always equal. If you’re making a short-term investment, the expense ratio generally isn’t very important. And remember that the most important thing when you’re picking an ETF is what the ETF owns in the first place. If you’re going to go buy a stock ETF just because it’s cheap even though what you were searching for was a commodity ETF, that’s a terrible idea.
Mark: Yeah, that’s probably even worse if you’re looking for a more conservative investment and then you go to an aggressive investment just because it had a really low OER.
Michael: Absolutely. If you’re saving money on cost but taking a lot more risk, that’s not good.
Mark: So let’s get back to all of those other costs that we talked about. The next one is the bid-ask spread. Some people call it the bid-offer spread. What is it, how important is it, and what type of investor should be most concerned about that particular cost?
Michael: Yeah. Well, whenever you sell or buy a stock or an ETF, there’s going to be some kind of transaction cost involved. And this is because usually you’re trading with somebody who is called a market-maker. So think of a market-maker like a vendor at a swap meet—they’re looking to buy goods at a lower price and then sell those same goods to somebody else at a higher price. Market-makers do the same thing with stocks and with ETFs—they will set a lower price, that’s the bid, and that’s the price they’ll buy shares from investors at, and then they’re going to set a higher price, they call that the ask, and that’s the price that they’ll be willing to sell to investors at. The difference between the two, that’s the bid-ask spread. For really popular ETFs, this might just be like a penny per share, but for ETFs that don’t trade as much, it can be expensive, even over 1% of your investment, just that trading spread. The spread tends to be the most important for investors who are going to trade ETFs really actively, only planning to hold them for a few weeks or months at a time. The more often you trade, usually the more you need to pay attention to that bid-ask spread.
Mark: So let me try to summarize that. So if the last trading price for an ETF was, let’s say, $10 a share, if you were to go buy that ETF as an investor, you would probably have to pay like $10 and one penny.
MARK: And if you immediately turn around and sell it, you may have to sell it for $9.99. So that spread, in that case 2 cents, that’s the bid-ask spread.
Michael: Yep, that’s right.
Mark: Now, a few pennies isn’t a big deal, but for some ETFs that spread can be … between the bid and the asking price, that can be a lot larger. So if the ETF is trading at 10, you might go in to buy it at 10.25, and then you … if you were to turn around and sell it immediately, you might get 9.75 for it.
Michael: Yeah, exactly. And that big gap there, that would be a huge percentage of your investment, and it’s just lost to trading costs.
Mark: So finally, we have commission. So the commission is what your broker charges you to process your trade, right?
Michael: Yes, exactly. So that’s what the commission is, and usually your broker is going to set the commission as just a fixed dollar amount, say, $4.95 every time you make a trade. If you look around, you’ll see that a lot of brokers these days, they’ll have some ETFs that you can buy or sell without being charged a commission, and that’s important, especially if you’re only putting a little bit of money into the ETF. The commission can be a big part of your cost if you’re only buying, say, a few shares of an ETF, or a small part of your cost if you’re investing a large amount of money at once. It tends to affects small-dollar investors the most, especially if they’re going to trade frequently.
Mark: Right. So if you’re buying a … making a $100,000 trade that you intend to hold for many years, 4.95 is not a big deal.
Michael: Exactly. But on the other hand, if you’re putting in a 100 bucks to an ETF and you lose $5 to trading cost, that’s a pretty big loss.
Mark: As in mentioned earlier, one of the decision-making errors we all make is to adopt overly narrow frames. In the case of ETFs, we’re suggesting people look at the total cost of ownership and not just the OER. But taxes are another aspect of cost, and by the time this episode airs, most listeners will be receiving their 1099s and their W-2 forms, and should be starting to prepare their taxes. So how are ETFs taxed?
Michael: Yeah, ETFs, they’re taxed much like stocks or mutual funds are. If you have an ETF and it owns stocks that pay dividends, then you’re going to get a dividend distribution from that ETF. If you've got an ETF that owns bonds and those bonds pay interest, you’ll get an interest distribution. And if you sell the ETF for a profit, then you’re going to owe capital gains taxes, just like you would with stocks or bonds.
Now, if you’re holding a more exotic ETF—you’ll see some that hold commodities or currencies—things can get a little more complicated. You might get form K-1 at a tax time, or you might see situations where your long-term gains get taxed at the higher short-term rate. But, usually, if you stick with regular stock and bond ETFs, they mostly work the way you would expect if you’ve owned stocks and bonds before.
Mark: So Michael, investments are sometimes talked about as being tax-efficient or tax-inefficient. What do we mean by that, and where do ETFs land on the tax-efficiency spectrum?
Michael: “Tax-inefficient,” that’s a term you usually hear applied to some actively managed mutual funds, and these are usually funds that are constantly buying and selling stocks in their portfolios. If a fund manager decides to sell one of their stocks, and they sell it for more than they bought it for, the fund itself has just made a capital gain. And if the fund manager has a lot of these capital gains, they will have to distribute those capital gains to you—usually, they’ll do that in December, at the end of the year—and now you owe taxes on that distribution, even though you haven’t sold your fund for a profit yet, and now you have to pay taxes. And that’s inefficient. Just hanging onto the fund, you might still have to pay capital gains taxes, and a lot of investors, they don’t like that.
Now, when people talk about ETFs and they say ETFs are tax-efficient, what they mean is ETFs don’t tend to do what that actively managed fund did. This is mostly because the vast majority of ETFs are tracking indexes, and when you track an index, that means the fund manager is usually holding onto securities for a long time without selling them. So because ETFs are index funds, there’s very little turnover, and that means they tend to garner little in the way of capital gains.
Beyond that, when investors want to redeem their mutual fund holdings, the fund has to sell securities to get money to cover the redemption, and now that mutual fund might generate capital gains. But remember, ETFs trade like stocks, so if an investor wants to sell out of their ETF, they just sell it to some other investor, and that means the ETF doesn’t have any capital gains.
Mark: Michael, you mentioned indexes, and that reminds me of an important aspect of ETFs that we haven’t really covered a whole lot. We defined an ETF as a basket of securities, but we haven’t talked about how the securities in that basket are chosen. So how is that decision made?
Michael: Well, most ETFs are aiming to track some kind of index, and an index, it’s just a list of stocks or bonds or some other type of investment. The ETF manager’s job is to make sure the ETF owns securities, stocks or bonds, that are very similar to what the index lists, and sometimes they’ll do that with what’s called full replication. In full replication, the manager of the ETF literally just buys every security in the index in exactly the same proportion that the index lists it. On the other hand, sometimes an ETF manager will do something called sampling, which means they’ll leave some securities out of the ETF, even though they’re in the index, and they’ll put that money elsewhere into the other securities of the index, so that the overall portfolio is pretty similar to the index.
Mark: And a lot of that is because some indexes just have so many, they have thousands and thousands of securities. It’s just not really possible to buy them all, right?
Michael: Exactly, especially bond indexes. You won’t usually see every single of the thousand bonds in an index inside an ETF.
Mark: But at the end of the day, the ETF is going to … if it’s managed well, is going to track that index … the price of the ETF is going to track that index closely.
Michael: Exactly. If the manager is doing their job and the index is up 3%, the ETF should be up about 3%, as well.
Mark: So what’s the connection, then, between the index approach and the low costs that seem to attract people to ETFs in the first place?
Michael: Well, with an index approach, especially one that an ETF can fully replicate, the decisions that the portfolio manager has to make are pretty straightforward—buy the stocks and the bonds that are in line with this list in the index. Now, if you look at an active strategy, though, that manager has to decide what to buy and sell, which means they need a more involved investment process. So maybe that active manager is hiring analysts who are traveling around the country, and they’re researching companies and talking to CEOs, or maybe they do something like build a sophisticated data-intensive computer model, and that will help them identify which securities to invest in. That type of decision-making—that requires money. You've got to hire people or build these high-tech systems. So active management tends to be a little more expensive. Index managers, they don’t need to spend money on those things, so they can keep their costs pretty low.
Mark: So that applies to index mutual funds, as well. They tend to be much less expensive than actively managed mutual funds, for the same reasons.
Michael: Exactly. If you’re going with indexing, it’s usually cheaper than active management.
Mark: So how important is the index to the investor when selecting an ETF?
Michael: Well, if you’re looking at a low-cost, kind of vanilla ETF that’s just trying to represent a whole broad array of stocks or bonds in a market, you’ll find out that most of the index providers out there, they tend to follow pretty similar approaches. In a case like that, the specific index that the ETF tracks is not usually the most important decision. But if you’re looking at so-called smart beta ETFs that track indexes that are aiming to perform better than the broad market, then the specifics of the index will matter a lot. For that type of ETF, you’ll want to think about picking the index similarly to how you would think about picking an active manager. You want one that you think has a good chance to outperform the market without taking on too much risk.
Mark: That’s a lot of great information, Michael. Thanks for coming by.
Michael: My pleasure, Mark.
Mark: One mistake people make when it comes to financial products is to think that all financial products, like ETFs, are alike. And that’s just not true. Financial products are tools, and just like tools at a hardware store, there are many different types. For example, go into a big-box hardware store and look at their selection of screwdrivers. There are many different types and many different sizes of the same type. Pick the wrong one, and you may find it difficult to complete that home repair task.
The question about which ETF is right for you is a lot like asking which screwdriver is right for you. You can’t answer it without taking a step back and looking at all of your accounts and understand what you already hold. Diversity is important and you don’t want to accidentally double-up by purchasing ETFs with similar holdings to what is already in your portfolio. Then think about what you are trying to accomplish with your portfolio in the first place. The best place to start your search is to find ETFs that track indexes that are consistent with your goals as an investor. In fact, that’s probably the most important thing.
The next step is to narrow that list by looking at the total cost of ownership, given your particular approach to investing. For example, if you’re making regular small investments, then pay special attention to commission-free ETFs. If you’re making large purchases that you intend to hold for years, then the expense ratio probably matters the most. Finally, if you’re an active trader who is trading frequently, pay attention to commission-free ETFs with tight bid-ask spreads.
If you would like to learn more about ETFs or see Schwab’s wide selection of ETFs visit schwab.com/ETF.
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For important disclosures and a transcript, see the show notes and schwab.com/financialdecoder.
 Based on Morningstar data for all ETFs 6/30/2008 compared to the same 12/31/2018 data.