ETFs: Facts and Fictions
By Robert Gordon, Twenty-First Securities Corporation 

Originally published in Risk-Controlled Investing, November/December 2005.  Charter Financial Publishing Network, Shrewsbury, NJ  07702. 732-450-8866.  

Exchange-traded funds (ETFs) are popular because they provide the benefits of traditional indexing and they can be traded throughout the day.  However, ETF investors should be aware of these funds' extra and sometimes hidden costs: bid/ask spreads, commissions going in and out, and substantial discrepancies between the ETF and the index it purports to track.

ETFs (like stocks) have a spread between the bid and ask price.  Twenty-First Securities' (Bob's firm) most recent research, covering over 300 ETFs, calculated the average bid-ask spread for ETFs to be 0.38% of the ask price.  For the SPDRs (Standard & Poor's Depositary Receipts), one of the most well-known and widely traded ETFs, the spread averaged only 0.01% of the ask price -- but don't think that's how they all trade.

Twenty-First Securities anticipates that wider spreads will persist in the foreign markets and in indexes with less liquid securities.  With countries where markets are closed while United States markets are open, large spreads will probably continue because the market makers can't efficiently layoff their risks.  If actively managed ETFs get off the ground, we predict spreads will be substantial because dealers will no know what securities are in these funds.

In addition to spreads, ETF investing also involves standard brokerage commissions, unlike open-end funds.  And in addition to these frictions, all ETFs have tracking errors -- errors stemming from inaccurate replication of the benchmark.  Often these discrepancies are miniscule, but not always.  For example, Bloomberg Wealth Manager reported that the 2004 tracking error for iShares' MSCI EAFE Index Fund amounted to 129 basis points.

For certain types of investments, no load open-end mutual funds may be more efficient than ETFs because spreads and commissions are nonexistent.  Index options have no tracking error and tax advantages but do entail commissions and bid/ask spreads.

Despite their drawbacks, ETFs remain highly competitive investments for those with long-term investment horizons.  But any investors who are considering these vehicles should begin by kicking the tires and not rush into Wall Street's latest fad.

For more information on the advantages and disadvantages of ETFs, see our newsletter articles, "SPDRs: A Streamlined Approach to Indexed Investing" (March 1999) and "Are Exchange-Traded Funds Doing Their Job?  Notes on a New York University Conference" (Summer 2002).  Both articles are available under "Newsletter Archives" at Twenty-First Securities' home page, www.twenty-first.com.  For information on index options, see "How Are Your Index Options Taxed?" under "Investment Tools" at www.twenty-first.com.

Robert N. Gordon is the president of Twenty-First Securities Corporation, which he founded in 1983 and has been in the brokerage business since 1976.  For copies of Twenty-First Securities' most recent ETF spread analysis, call 212-418-6003.