The ETF: Portfolio Management’s Best Tool
We believe ETFs’ superior cost, transparency, and tax management make them the ideal investment tools for the modern world.
ETFs are low-cost, transparent, and tax-efficient.
ETF price fluctuation throughout the day allows for more granular tax loss harvesting and rebalancing opportunities.
Intraday trading also allows ETFs to be price discovery tools when the markets of the underlying investments are closed.
This article was co-written by Ellie Lan, an investment analyst at Betterment, and Dan Egan, Betterment’s Director of Behavioral Finance and Investing.
When John Bogle, Vanguard’s founder, pens an op-ed calling ETFs “the greatest marketing innovation,” we had to read it. And we’re happy to see that we agree with him for the right reasons … and disagree with him for the right reasons.
For a quick review, unlike mutual funds, ETFs can be priced and traded intraday by exchanges and market makers. Mutual funds can only trade once per day, right after the close of the markets.
Mr. Bogle quite rightly is concerned that ETFs can trade intraday means that some investors will speculate with them by buying low in the morning, and selling high in the evening. Such short-term speculating is likely to harm long-term successful investing. On that score, we’re 100% with him.
However, the difference in how ETFs and mutual funds trade and price has significant benefits for portfolio management, too. For one, ETFs trade throughout the day, and therefore see a wider range of prices in a single day, allowing tax loss harvesting and rebalancing to provide more value.
In fact, we believe ETFs’ superior cost, transparency, and tax management make them the ideal investment tools for the modern world. For example, ETFs are more transparent, as they don’t embed 12b-1 fees, which a salesman or broker can earn from selling the mutual fund (creating a conflict of interest in the mutual funds they sell). Here, we’ll focus on how ETFs are superior investment vehicles when it comes to portfolio management.
When it comes to portfolio management, short-term fluctuations in the prices of securities may not be a bad thing—they can create more opportunities to rebalance and tax loss harvest. These aren’t short-term speculative moves—they are long-term tax and risk management benefits, made possible by efficient technology. In addition, they can more correctly reflect current underlying prices.
However, because of intraday fluctuations, it is possible for ETFs to trade at prices very different to the underlying index in the very short term. If you care a lot about getting a perfect price open-end mutual funds may be more attractive, as they always are priced at the net asset value of the underlying assets… but once per day, after close. The one-time pricing has its own downsides.
Fund Types and Characteristics
|ETFs||Open-End Mutual Funds||Closed-End Funds|
|Share price determined by supply and demand||Yes||No, price determined by net asset value of the underlying assets||Yes|
|Can new shares be created?||Yes, through creation and redemptions||Yes, through creation and redemptions||No generally, the pool of money collected for the investment vehicle does not change after the initial IPO however shelf programs can be created to help w/ liquidity|
|Can trade at premium/discount to NAV||Yes||No||Yes|
Below we took a look at how intraday changes could significantly affect how your portfolio is managed by comparing the frequency of tax loss harvesting and rebalancing when observing intraday prices rather than just closing prices. The chart below depicts the close-to-close return (represented by the dot), which is the closing price for a certain date compared to the closing price of the day before. We’ve normalized it so that all close-to-close returns have a value of zero, to compare other returns to. It also shows the return generated by the daily high and low of intraday trading for EEM, the iShares MSCI Emerging Markets ETF.
This lets us see the range of returns we observe with an ETF compared to a mutual fund. When the close is the high or low price of the day, the high/low bracket is not plotted. As you can see, on the vast majority of days, the highest or lowest return is very different from the close to close return. In other words, ETFs have significantly more tax loss harvesting opportunities (the lows) and rebalancing opportunities (both lows and highs) than mutual funds.
One-Day Range of EEM Returns
Prior Day Close to Today’s High and Low
The Opportunities for Intraday Trading
Most days have a range of returns that is significantly different from the close-to-close return. Both mutual funds and ETFs price daily, but only ETFs can trade intraday. How much opportunity actually occurs intraday? And, more importantly, how much incremental opportunity does intraday provide? It turns out, quite a lot. In the table below, we present the count of observing a 3% loss, when looking at close-to-close prices for one day’s return.
Count of Close-to-Close Losses Intraday
The above table shows four different ETFs, each representing a different asset class. We chose the AGG, a bond ETF that encompasses the broad U.S. bonds market; VTI, the total U.S. stock market ETF; EFA, a developed markets stock ETF; and EEM, an emerging markets ETF that covers the emerging markets. We chose these ETFs because we wanted to look at several different geographies and asset classes.
The table above illustrates the number of times one can expect a mutual fund (using close-to-close returns) to experience a portfolio management event, whether it’s tax loss harvesting or rebalancing, because the mutual fund experienced a 3% loss. As we move down each column, the loss level hurdle increases and the number of occurrences decreases for all four funds.
If we look at the same data below, but for close-to-low prices (the difference between closing price and the lowest price for that day), we have how likely it is that an ETF sees a given loss when we can observe intraday prices. The number of occurrences increases by a significant magnitude if an investment trades throughout the day rather than trading only once at market close.
Count of Close-to-Low Losses Intraday
The table below shows the increased odds of seeing a level of loss for an ETF relative to a mutual fund. As you can see, being able to trade intraday generally creates roughly a 2x increase in potential tax loss harvesting opportunities per day.
Increase in Likelihood of Loss Intraday
It might not be obvious, but these are intraday return differences that are resolved by the end of the day—ETFs and mutual funds have the same close-to-close return. So these are ephemeral opportunities to tax loss harvest and rebalance.
But the good news is even if we look over larger periods, we still see significant increase in potential tax loss harvesting opportunities by looking at intraday prices. Instead of looking at just the one-day intraday differences, we can check on a longer five-day range, and find that ETFs will still see many more opportunities to tax loss harvest and rebalance than mutual funds.
Increase in Likelihood of Loss Over Five Day Period
Up-to-Date Prices on International ETFs
The fact that ETFs can price intraday provides other benefits. With ETFs that track international indexes, but trade here in the United States for local investors, when the international markets are closed investors can use them to provide an estimate of the value of the underlying index.
This is especially true with international ETFs because when the underlying markets are closed, the ETF still trades in the United States. As information and news about those countries break and are continuously processed throughout the day, the prices are not reflected by the underlying securities (as that market is closed) but are reflected in the prices of the ETFs that trade in the United States. So if you look at the net asset value (NAV) of a mutual fund, it probably doesn’t reflect the most up-to-date information about the price. But the ETF will.
The reality is ETFs are sometimes the only tools for discovering the price at which the underlying assets should trade. While they may not reflect 100% accurately the movement in the underlying market, ETFs hold substantial predictive value when it comes understanding the underlying market.
Bogle may have penned an attack on ETFs, his attack is really an attack on trading concentrated niche ETFs that are active in nature for speculative purposes. Betterment’s portfolio of ETFs are all passive ETFs that track an index. We never buy or sell for speculative purposes. Rather, we trade if there’s value to be gained from portfolio management. The way that Betterment uses ETFs very much resembles Bogle’s philosophy of long-term index investing: buy and hold, and don’t try to beat the market.
This article originally appeared on ETF.com.
More from Betterment:
How Betterment Works During Volatile Markets
It can be difficult to ride out a market downturn when you can see it affecting your investment portfolio. We have automated features in place to address volatile markets when they occur.
Congress Just Passed the SECURE Act—Here’s What You Should Know
The government is taking steps to make your retirement more secure. Find out how the new changes might affect you.
Betterment Everyday™ Cash Reserve | High-Yield Account
Explore Cash Reserve, a high-yield cash account designed to help you earn more on the cash you save.
Explore your first goal
Our high-yield account built to help you earn more on every dollar you save.
This is a great place to start—an emergency fund for life's unplanned hiccups. A safety net is a conservative portfolio.
Whether it's a long way off or just around the corner, we'll help you save for the retirement you deserve.
If you want to invest and build wealth over time, then this is the goal for you. This is an excellent goal type for unknown future needs or money you plan to pass to future generations.