Index Funds or ETFs?

Journal of Financial Planning: December 2015


Rick Ferri, CFA, is an investment adviser, speaker, and financial writer. He continually monitors the latest trends related to index funds and ETFs. His research appears frequently in many major media outlets.

Should you use ETFs rather than index mutual funds? That’s a tricky question—and an important one. Mutual funds are a relatively straightforward investment. You buy and sell shares directly with the fund company or through a broker and everyone gets the same daily price, the fund’s net asset value (NAV).

ETFs are more complex. The shares trade on exchanges rather than with the fund company. Only authorized participants (APs) may create and redeem shares directly with fund providers. An indicative net asset value (iNAV) estimates the NAV during the day, but it’s always a few seconds old and is just an educated guess. No one really knows an ETF’s exact NAV during trading hours because it’s not calculated by the fund company until the end of the day.

Advisers who use ETFs in lieu of index mutual funds should be aware of problems that could occur when an ETF’s underlying securities have become temporarily illiquid. If you’re selling and you are unaware of an illiquidity issue in the market, you and your clients may be in for a nasty surprise when your trade settles. There have been several highly publicized occasions when ETF market prices fell well below iNAV because the underlying securities stopped trading for excessive volatility or some other reason.

Consider that some ETFs had a bad day on August 24, 2015. The New York Stock Exchange enacted Rule 48, suspending the need for market makers to broadcast opening price indications. This caused APs to step back at the open, resulting in ETF prices dropping like bags of rocks.

The steep price declines tripped circuit breakers that temporarily halted trading for hundreds of ETFs. At final count, 471 ETFs stopped trading for at least one five-minute interval during the first hour of trading. At the end of the five-minute intervals, trading resumed in 30-second bursts. This is when some advisers sold ETF shares and received deeply discounted prices for their clients. It’s also when they realized they didn’t fully understand the ETF market.

Most indexes are available in both open-end mutual funds and ETFs, so the easiest way to avoid ETF trading problems is to not use them. That’s simple enough for advisers at RIA firms that custody at Schwab, TD Ameritrade, and similar brokerage firms that provide access to Vanguard funds and other index fund providers. If you fall into this category, the commissions your clients pay to trade an open-end index fund may be slightly higher than trading ETFs, but you’ll never have to worry about explaining to them the potentially disappointing realities of an ETF’s iNAV intraday pricing “gotchas.”

If you only have access to indexes through ETFs, implementing a few simple trading rules can help avoid price surprises.

Avoid trading ETFs until one hour after the opening bell. ETFs often take a while to find their footing because it takes time for all of their underlying securities to open. If you try to trade too early after the bell, APs may demand wider spreads as compensation for taking greater risk.

Avoid trading ETFs in the last hour before the closing bell. APs and other traders are stepping back to assess and limit their risk going into the close. Spreads widen as participants leave the market.

Monitor an ETF’s trading volume before placing orders. Try to ensure there is sufficient volume to enable efficient trading. Also consider placing ETF orders as a buy stop-limit or sell stop-limit. This will help prevent your trades from being executed at a bad price. Also, you’ll need to adjust your order if the market moves against your trade.

Both open-end and exchange-traded index funds can help you offer clients effective, low-cost vehicles for capturing market returns according to their individual goals and risk tolerances. This is especially so if you consider how far we’ve come since Vanguard’s Jack Bogle introduced his first index fund in 1976. But, as you would for any powerful device, it’s important to read and understand the owner’s manual before firing up the engine. ​

Investment Planning