out and spending the physical capital. Usually, it does.”
However, it should be noted that you can also get hurt trading ETFs if you aren’t careful or rack up some unwanted trading costs. We will dive deeper into ETF liquidity and trading in Chapter 5.
Tax Efficiency
While there are few minor exceptions, ETFs overall have a near-perfect record of not issuing capital gains taxes that can plague mutual funds and hedge funds. Obviously, this advantage means zilch for an institution that is tax exempt. But as you go beyond tax-exempt institutions, it matters and is certainly, by anyone’s standards, a nice residual benefit of the ETF and worth an explanation.
When there are large redemptions in a mutual fund, the manager must go and sell some stocks in the fund in order to cash out the big investor. Selling those stocks for a gain can trigger a tax event for the fund, which affects all of the existing investors. In other words, the good soldiers who stayed in the fund have to foot the tax bill of the people leaving. Alternatively, the fund manager could keep cash on the side for redemptions, but then they have cash drag on returns.
In contrast, when someone sells their shares of an ETF in the open market for a gain, that is on them and it does nothing to affect investors in the ETF. This is due to the way ETFs shares are created and destroyed using an “in-kind” method which we will learn about in Chapter 3.
The bottom line is ETFs shift the tax burden onto the seller, not the existing shareholders. This makes ETFs even more tax efficient than traditional index funds, as seen in Table 1.5.
Table 1.5 Asset-Weighted 5-Year Average Capital Gains Ending 2011
Source: Morningstar, Inc.
Transparency
Transparency is a value that many people hold dear in all aspects of life. We like transparency in our government (even though it is rare), our relationships, our community, and our business. So it is not a shocker that it is a valued trait of ETFs. ETFs are considered transparent because almost all of them report their holdings every day. This is an advantage that is best contrasted to mutual funds, which only report holdings quarterly and with a 60-day delay, and hedge funds, which never report the holdings of their funds.
Knowing what is in your ETF can come in handy in monitoring overlap with other investments. If a stock has some kind of major event, you can check quickly and know how exposed you are to it. In an actively managed fund you just don’t know.
For example, if Elon Musk suddenly quits Tesla today, you could quickly figure out how much Tesla you are exposed to across your ETFs and make any necessary adjustments. With mutual funds, you’d be looking at data that were four to six months old, so you’d be in the dark, having no idea exactly how bad the situation was for you.
Figure 1.1 shows us the ETFs and mutual funds that have the biggest weighting to Tesla as of 6/16/2015. You can see that all of the ETFs have holding dates as of the day before, while the mutual funds are months old, and you don’t know if they’ve beefed up or unwound that Tesla position.
Figure 1.1 ETFs Show Their Holdings Every Day
Source: Bloomberg
There is one caveat to ETFs’ daily transparency and that is Vanguard. Vanguard only releases their ETF holdings monthly with a 15-day lag. Across only Vanguard’s ETF roster the ETF exists as a share class of Vanguard’s index mutual funds, and as such they don’t want those funds to be victims of front-running by disclosing holdings daily like other ETF providers do.1 Many of the early issuers chose to voluntarily disclose daily holdings for competitive reasons, but not because they are required. Still, the stand alone, transparent ETF structure is a consistent improvement relative to other types of funds.
Diversification
Whether it is small caps, China, or biotech, there are just areas where even a large institutional investor simply won’t have an opinion or research on single security names. They may not have the resources to study the area or have chosen not to make a single security bet. ETFs offer an alternative to this by offering exposure to an entire market or country or sector.
“I’m a stock picker, but I use ETFs for things I don’t know about.”
Let’s say you are interested in getting exposure to health care. There are hundreds and hundreds of stocks to choose from. Which one do you pick? Many people will opt to use an ETF, which puts your eggs in many baskets. In this way, ETFs let you be more of an economist and less of a stock analyst.
Another important aspect of diversification is dampening volatility. Investing in a group of securities protects you from single-company blow-ups.
Let’s look at an example using the Guggenheim Solar Energy Index ETF (TAN). In October 2014, a sapphire glass company named GT Advanced Technologies Inc. (GTAT) declared bankruptcy after Apple decided not to use their glass in the screen of the iPhone 6.2 The stock quickly dropped 90 percent – a nightmare scenario for GTAT’s stock holders. Imagine if you were bullish solar energy but had only bought GTAT.
Meanwhile, TAN barely noticed it. GTAT was a 3.2 percent weighting, so its contribution to total return (CTR) for TAN on the year was 0.72 percent, as seen in Figure 1.2. Not desirable, but pretty minor considering the stock blew up. ETFs help investors play their themes without the stock selection process undoing the thematic or allocation work up front.
GTAT was also immediately thrown out of the index because it broke the index rules by declaring bankruptcy. This example also exhibits an ETF’s regeneration process – a benefit that doesn’t get brought up too often. Because ETFs track indexes and because those indexes have rules, if a company slips up and breaks the rules, it is going to be kicked out of the index and replaced with a new one.
Not every company burns out; some fade away and before long they are replaced. This Darwinistic process helps your ETF stay in playing shape and evolve with the times. And you don’t have to lift a finger – it’s all done as part of the normal periodic reconstitutions and rebalances and of the index. Figure 1.2 shows the weekly holdings of TAN during October 2014. In the case of GTAT, it was quickly booted out of the index within days of its bankruptcy.
Figure 1.2 TAN’s Holdings Each Week during October 2014
Source: Bloomberg
“ETFs reduce the risk of a WorldCom or an Enron. You have so many risks using just one stock. How do you know there is not fraud risk or an accounting error or a bad product? There’s no way we can do that level of due diligence to figure out if that’s occurring. The ETF is rebalancing. It’s taking out the losers and putting in the winners. We don’t have to do that.”
Bankruptcies and frauds aside, diversification also dampens day-to-day volatility as well. For example, TAN holds 32 companies involved in the solar energy business. Most are newer, younger, and smaller companies. The average standard deviation for each of the 32 stocks is 63 percent. Meanwhile, the ETF’s standard deviation is about half that, at 38 percent. That is still about triple the standard deviation of the S&P 500 index, but it is just much less volatile than the stocks