Since the beginning of this month traditionally marks back-to-school time for many, I thought the timing was appropriate for this article on basic investor education with a focus on ETFs and similarly traded instruments. The following seven actions reflect practices, many quite common, I’ve seen executed often that I consider major mistakes. In fact, I strongly advise most investors never to take these actions. Moreover, I personally believe they fall short of best practices for most fiduciaries and advisors. The last two may be especially controversial and do not apply to expert short-term traders or mega-institutions. There is an abbreviated list of the seven actions at the end of this blog if you are limited on time.
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1. NEVER assume something is an ETF because it trades like an ETF and is referenced in the media as an ETF. There are nuances in the structures that can lead to unpleasant tax surprises, price behavior differing from prices of underlying assets and exposure to counter-party credit risk. Examples of these types of products are GLD, SLV, USO, UNG and AMJ. GLD and SLV are direct interests in grantor trusts and are taxed at the higher IRS rate for collectibles, not as capital gains. USO and UNG are shares of commodities pools and subject to contango and supply issues. AMU is an exchange traded note that has counter-party risk with Barclay’s Bank. It’s fine to allocate funds to exchange-traded commodities and notes, but not before a thorough read so you understand the implications.
2. NEVER purchase an ETF without accessing and reading its fact sheet and summary prospectus. At a minimum, know what the structure is of what you are buying, whether it is an active or passive index, or an algorithmic index, and its stated objective. Deep dives are better. For example, there are “value” ETFs that hold Google and Amazon.
3. NEVER submit a market order to buy or sell an ETF. Market orders to purchase shares will be executed at the most recent “ask” price which may be close to the last sale or may be much higher depending on the ETF and the market. One of the major benefits of ETFs over mutual funds is knowing how much you will pay for a share of your fund when you buy it so why pay more for the share than necessary? Also, market orders for ETFs during the flash crash resulted in huge and unexpected losses. Place a limit order less than or equal to the ‘bid” price. This is generally preferable for individual stocks as well. It avoids setting you up to be “picked off” at a higher buying price or a lower selling price by professional traders. Most ETFs have a ticker listed on the factsheet for the indicative Net Asset Value per share of the fund which can be used as a guide for limit order pricing on funds that exclusively contain US securities.
4. NEVER EVER use a stop loss order to sell ETFs or anything else for that matter. This is an invitation for professional traders to take the ETF’s price down to your execution level.
5. NEVER think you are buying the US stock market by purchasing DIA, the ETF based upon the Dow Jones Industrial Average. The US market has more than 6000 stocks. Its exposures cannot be captured by 30 stocks. There are many other problems with DIA as an investment as detailed in an earlier blog article http://blog.valuengine.com/index.php/cap-weighted-vs-equally-weighted-sp-500-etfs-which-is-better/
These last two rules will shock some people:
6. NEVER buy new shares of GLD. I wrote about this in a previous blog article: http://blog.valuengine.com/index.php/should-gold-have-a-roll-in-your-portfolio/ Nevertheless, most people still believe GLD is the ETF they should buy for their clients if establishing or increasing a position in the precious metal for themselves and/or their clients. They are wrong on both counts. As mentioned in my first point, GLD is not an ETF at all. Its structure is a grantor trust and its tax treatment when sold is at the higher level of a collectible in lieu of capital gains on a stock. The second point has to do with fees which was covered in the earlier article. GLD, SPDR Gold Shares, is by far the largest Exchange Traded Product to own gold with nearly $60 billion in the trust. It is also the most widely traded, a point often used to justify paying its high fee of 0.40%.
The fact is that there are three major alternatives that have been in the market for more than three years:
- IAU, iShares Gold Trust by iShares (0.25%);
- SPTM, SPDR Gold Shares Mini, also by SPDR (0.18%); and
- BAR, Granite Shares Gold Trust by GraniteShares (0.17%)
All have substantially lower fees, the last two more than 50% less than GLD.
In July, iShares launched the least expensive alternative yet, IAUM. They named it iShares Gold Trust Micro. Although the SPDRs and iShares press releases at the time SPTM and IAUM were released state that these “mini” and micro products, brought out at lower prices-per-share were “designed for smaller investors”, there has been ample liquidity for purchase without causing market impact in IAU, SPTM and BAR in three years of trading. I suspect the same will be true of IAUM.
The price-per-share of a stock in these days of zero-fee trading seems like a weak explanation. To me, and I admit having no first-hand information on this, it just seems more likely that the institutions made a business decision to compete with BAR on price for new shares without losing the higher margins of investors already in GLD and IAU. Those investors might not want to switch from GLD to GLDM or from IAU to IAUM because the taxes they would incur might be greater than the eventual cost savings due to the differences in fees.
Please keep in mind that fees are generally not the only consideration for Exchange Traded Product (ETP) investors. There are equity and fixed income ETFs with similar names that can have very different holdings so only focusing on fee can lead to not buying the best product.
That simply is not true here. All of the above ETPs are backed by gold bullion. BAR has the added twist of issuing shares backed by physical gold shares already in a vault, but that is of little consequence to most investors.
I need to mention that there are a few exceptions to the above statements. Mega-institutions such as sovereign wealth funds and huge pension plans might indeed need the liquidity present in GLD or IAU in order to avoid moving prices substantially. More commonly, hedge funds with very short-term holding periods do not care about fees and focus on mega-liquidity instead. There is also an application that some wealth managers may deem appropriate at times for their clients, a buy-write strategy, holding the gold ETP while writing options on the ETP. Only GLD and IAU currently have listed options and GLD options are much more liquid. If the advisor deems that the options income expected to be derived will greater than the additional fee costs added to the expected taxed on the options income, GLD might be the ETP of choice.
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The vast majority of investors wanting to increase or begin their allocations toward gold should place limit orders at or below the bid price for IAUM if it develops any type of volume and BAR otherwise. The size and volume of GLD do not justify paying more than twice as much as BAR and IAUM for identical ownership.
7. Finally in my opinion, you should NEVER buy new shares of SPY. I realize that this is almost heresy. After all, SPY, the first successful US ETF, is the largest mutual fund in the world with over $400 Billion dollars under management. Beyond that, The argument for SPY most frequently advanced is that it has by far and away from the highest daily dollar trading volume. However, it is systematically more expensive and less efficient in producing total returns than very liquid and highly traded alternatives IVV from Blackrock’s iShares and VOO from Vanguard. As always, I recommend downloading the ETF Fact Sheets and summary prospecti for yourself. There you will find the following major differences between SPY and both IVV and VOO:
a. The expense ratio is 0.095% as compared with 0.03% for both IVV and VOO.
b. SPY is structured as a Unit Investment Trust. It has a Master Trustee that can effect changes in the fund that reflect changes in the S&P 500 Index. However, it is structurally prohibited from reinvesting its dividends and/or lending its securities. Those differences cost SPY an average of 0.06% per year in comparison with IVV and VOO.
c. The combined result of both differences has resulted in annualized total returns systematically lower for SPY by about 12.5 basis points (0.125%) per year in each time frame. The table shows annualized returns for 1- 3- 5- and 10-year periods ending 06/30/2021:
|ETF||1-Year Ann. Tot. Ret.||3-Year Ann. Tot. Ret.||5-Year Ann. Tot. Ret.||10-Year Ann. Tot. Ret.|
d. Although 0.125% per year may not seem enormous, after 30 years of compounding, the gross difference is 45%. On a $500,000 initial investment, you will systematically make close to $740,000 less with SPY than with VOO or IVV.
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In summary, these are seven simple rules I recommend when using ETFs and other Exchange-Traded Products:
- Always download the Fact Sheet for the exchange-traded product you are about to buy to make certain it is an exchange-traded and open-ended mutual fund, not a grantor trust, a debt instrument or a share in a commodities pool.
- Read the Fact Sheet to make certain you know what type of management structure you are buying: a cap-weighted passive ETF, an ETF governed by an algorithmic index or an ETF that is actively managed. For a deeper dive also look at the ETF’s website to scrutinize holdings and characteristics. It is also a good idea to download the summary prospectus. Avoid unpleasant surprises.
- Purchase and sell ETFs using limit orders, not market orders.
- Avoid “stop-loss” orders in general. This is even more true for ETFs.
- The Dow Jones Industrial Average has many peculiarities which makes it a poor core holding intended to represent the US Stock Market and it has been many years since its holdings could be considered America’s Blue-Chip Companies. Generally speaking, you should buy an ETF based upon the S&P 500, Russell 1000 or even broader indexes for your core US equity holding.
- When buying new shares of an Exchange-Traded Product holding gold bullion, choose between IAUM (fee: 0.15%); BAR (0.17%) and SPTM (0.18%). Check all three to make sure they meet the liquidity requirements for the size of your trade, then select the one with the lowest fee that does so. Avoid GLD (0.40%) unless implementing a buy-write strategy or executing a huge trade.
- For core US equity exposure to the S&P 500 Index, buy Vanguard S&P 500 ETF VOO or iShares S&P 500 ETF IVV. An interesting core alternative I happen to own is Vanguard Total US Market, VTI, that holds the S&P 500 plus more than 3500 other US-listed stocks and charges the same 0.03% fee. New shares of SPY will systematically cost you an extra 0.125% per year. So, only buy SPY if you want the status of telling friends that you own the oldest, largest, and most famous US-listed ETF in the world. OK, I must admit that it also has a really cool ticker symbol.
By Herb Blank
Senior Quantitative Analyst