Global exchange-traded fund provider Vanguard has released a white paper comparing the benefits of mutual funds and ETFs, which finds that intra-day market prices – seen when trading ETFs – reflect valuable information about market conditions.
European ETF assets have risen above $500bn, while asset accumulation has maintained strong momentum, growing at an annualised rate of 86.8% in the four years ending in Q3 2015, vs. 33.4% for mutual funds
The research entitled “Exchange-traded funds: Clarity amid the clutter” looks at how the historic range of premiums and discounts to the ETF’s net asset value may provide information regarding market conditions for the underlying asset type. Firstly, European ETFs exposed to foreign assets exhibited wider fluctuations in premiums and discounts over time compared to those covering local assets due to the ETF being actively traded while the market for the underlying assets was closed. As new information regarding the underlying assets is released, ETF investors have the opportunity to trade their shares based on what they believe the assets would be worth if the market was open. As such, the ETF’s price tends to deviate away from the stale closing prices of its underlying assets.
The paper also finds that deviations from underlying value is reflective of expected transaction costs and fees incurred by authorised participants in redeeming or creating shares of the ETF. While this function is important in maintaining liquidity in the secondary market, it can lead to premiums or discounts to net asset value. For example, there is greater variability with European bond ETFs relative to European equity ETFs because of the increased complexity of bond transactions. Similarly, corporate bond ETFs display higher variability than their government bond counterparts due to the increased complexity of corporate bond transactions vs. government bonds. During times of lower liquidity in the underlying markets, these premiums or discounts could expand.
The paper also highlights the increasing popularity of ETFs among investors. Not only have European ETF assets under management risen above $500bn, but asset accumulation has maintained strong momentum, growing at an annualised rate of 86.8% in the four years ending 30 September 2015, versus 33.4% for mutual funds over the same period, according to Morningstar figures.
Vanguard states that strong growth in ETFs has been driven by the low cost nature of the products, but also the shift in intermediary’s compensation structure from commission- to fee-based. This latter trend has resulted in an uptick in the use of passive products to gain desired exposures.
The fact that the vast majority of ETFs are set up as passive investment trackers – 99% compared to only 7% of mutual funds (Morningstar 30 September 2015) – serves to illustrate their recent appeal. According to Vanguard, the often touted low cost benefit of ETFs is primarily due to their passive nature, with passive mutual funds charging similar fees.
Beyond this, ETFs and mutual funds share many similar characteristics including similar regulatory regimes, investment strategies, asset allocations, economies of scale, and diversification benefits.
ETFs do however provide additional benefits largely because of how investors transact in fund shares. Secondary market liquidity in ETFs allow investors to trade a broad portfolio of securities without trading in the primary market of the underlying securities. Vanguard’s calculations show that, on average, 99% of European equity ETF trading volume is conducted in the secondary market, thereby avoiding portfolio management impact and trading in the underlying securities.