ETF Trading Is Good For You …

September 12, 2008

... even if you don't trade ETFs.

Jim, your last blog was great. Hey, everybody gets lucky sometimes. I actually agreed with almost everything you said. But for those readers less familiar with ETFs, I wanted to back up a bit and explain one of your key points.

You wrote, "[T] the gist of it for US (the indexer tribe) is that all of this tremendous activity is making our market exposure cheaper, more tax efficient, and tighter to the market than ever."

This is very, very important. John Bogle may be worried about ETFs encouraging trading activity. As a long-term investor, you want there to be huge trading volume in your ETF. Every time someone trades an ETF that you own or are considering owning, they're putting money in your pocket.

Here's why:

First, it tightens the spread. Like any other stock, the more an ETF trades, the closer the "bid" and "ask" will be. So when you decide to buy or sell the fund, you'll get a price that's closer to fair market value. That's money in your pocket.

Second, it makes your ETF more tax efficient. When there is a lot of trading activity in an ETF, institutional investors are working in the background to "create" and "redeem" shares of the ETF. To create shares of an S&P 500 ETF, for instance, they'll buy up all the stocks in the S&P 500 and send that package to the ETF company in exchange for shares in the ETF; to redeem shares, they send in shares of the ETF itself and receive shares in all the stocks in the S&P 500 in exchange.

This creation/redemption process is the key to ETF tax efficiency. Each time shares are redeemed, the ETF provider can dispose of any stocks it owns with low cost bases without incurring any tax event. It just gives those shares to the institutional investor.

That's why an ETF like SPY (the S&P 500 ETF) has $26 billion in capital losses on its books, while something like the Fidelity Magellan fund has $5.5 billion in capital gains, according to Morningstar. Someday, Fidelity's capital gains could get distributed to Magellan shareholders, and that's going to hurt. With SPY, you're unlikely to get hit with a capital gains distribution ... ever.

Third, it keeps your ETF shares trading closer to fair market value. ETFs tend to track close to their net asset value, and the more trading there is, the better they do. All that trading makes it easier for arbitrageurs to exploit any difference between an ETF's share price and its fair value. And that's good for everybody.

The important thing to remember is this: There is no cost to you when someone else trades an ETF.

With a traditional mutual fund, long-term shareholders have to pay every time another investor moves into or out of the fund. If you own shares of a mutual fund and someone else redeems $1 million, the fund has to sell a bunch of stocks and pay transaction fees ... which reduces the value of your shares. It's fundamentally unfair.

With ETFs, transaction costs are borne by whoever's buying or selling the ETF; existing shareholders are shielded. So if you're a long-term investor, don't worry about all the trading activity in your ETF. In fact, celebrate it.


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