ETF vs. Mutual Fund

[gambler2075]

Can you please explain what ETF decay means? I always see ETFs discussed as long-term investment vehicles both by companies selling them and in financial publications due to their diversification and low expenses. I have never heard anyone say they are trading vehicles only and have never heard the term "decay" applied to them so I'm not familiar with it.

Essentially the problem is worse for leveraged ETF's... look at FAZ or FAS for example.

In a rangebound market, if the underlying index goes up 10% one day, back down 10% the next, back up the next, and back down the next, the index is where it started.

however, due to the math, the leveraged ETF's are not in the same place... they decay...

graphically it is best seen here:

Leveraged ETFs: Where ETF Decay Rules | Young and Invested

Basically, leveraged ETF's are great in a trending market, but horrible as an investment.

g

[kork13]

Wow, this has sure taken a turn... I have no interest in leveraging investments, and the loan I'm talking about happened over 3 years ago. It was used primarily to buy a car and yes, to jump-start my Roth IRA. However, that was a once in a lifetime opportunity, and one I'm loathe to repeat. Yes, it's "cheap money", and it really did help me get off to a good start, but at this point, I don't need to borrow money to invest (or do anything else for that matter, short of eventually buying a house), and personally see leveraging as a little irresponsible, akin to gambling -- if you don't get lucky with your trades, you're out money, and now have an even bigger problem on your hands.

In any case, I've already made my decisions/actions related to all this -- the extra cash I had has been invested, so it's all a moot point now.

[ramirezhenry55]

Thanks for enlightening me too on this matter mate!

[gambler2075]

Thanks for enlightening me too on this matter mate!

No problem. As you can imagine, if you think about it, if these leveraged ETFs decay, then why not short them? yes, people have come up with the idea of shorting BOTH types of leveraged ETF... so since FAS is the triply leveraged financial ETF and FAZ is the triple inverse financial ETF, on a day to day basis they pretty much mirror each other.

Take a look at this article... both FAS and FAZ were down greatly for the year...

FAS and FAZ: A Short-Seller's Dream? -- Seeking Alpha

so if you shorted BOTH then you would be guaranteed a huge return, right? Well, pretty much... first off, it is extremely hard to find shares to short, as the short interest is huge on each. Second, you have to rebalance fairly frequently, and if the market makes a huge, prolonged move in one direction, one of the triple ETF's may gain more than 100%. I remember going long FAS at 2-something in early march 2009, right at THE bottom of the markets, and I think it nearly tripled in a week or 2... of course I got out with like a 20% gain... oops.

But if you had shorted both FAS and FAZ at that time then you would have been hosed... the loss from shorting FAS could not be covered with the gain from shorting FAZ... hence the need for frequent rebalancing.

g

[TraderSmits69]

Not all ETFs are short term vehicles, there are some great index ETFs with very low expense ratios, a great alternative to mutual funds!

[tulog]

Can you please explain what ETF decay means? I always see ETFs discussed as long-term investment vehicles both by companies selling them and in financial publications due to their diversification and low expenses. I have never heard anyone say they are trading vehicles only and have never heard the term "decay" applied to them so I'm not familiar with it.

You are correct in that a non-leveraged ETF that tracks an index will be the safest type of ETF to invest in for a long period, as compared to a leveraged ETF, a leveraged inverse ETF, or a non-leveraged inverse ETF. Even so, in non-leveraged ETFs, normal decay exists results in a gradual loss in value due to fees, taxes, daily rebalancing, and capital gains distributions, and other managed expenses. A non-leveraged ETF will underperform the group of stocks it represents because of these ongoing costs of holding the stocks in the ETF; thus the value of the investment erodes, which I call normal decay. In leveraged ETFs, you also have exponential volatility decay, which is a far more serious problem, because the value of those ETFs, both long and short ones, are mathematically destined to go to zero. Additional volatility factors come into play such as options pricing (prices of options increase during volatile periods) since many ETFs use options.

Here is an explanation and illustration of volatility decay: Quantum Fading » Leveraged Decay

I do not believe in using an ETF being able to provide you diversification. Consider a "non-leveraged S&P 500 ETF". Is this the same as physically holding the same group of stocks? No, for a number of reasons including that the bid/price of ETFs is based upon the price that people are prepared to pay for them; and potential differences between daily net asset value (NAV) and closing price; and compounding of NAV errors as an incorrect price at close represents the trading open price for the next trading day. Also, I am concerned about the potential for fraud in that the ETF may not be holding the assets it says it will at any point in time, and that the prospectus only represents the ETFs holdings and investment objectives at a given point in time, and that nothing (except the threat of investor sentiment) could prevent changes to those objectives.

As to gambler's question of why not short these ETFs - first, you would have to find the shares which may not be available on a reliable basis unless you are an institution. You would have to have a non-tax deferred account. You would have to believe that the margin interest you were paying to borrow the stock is going to be less money than the money lost due to volatility. In a period of low volatility you would lose money. I am not sure how you would establish a system that could predict when volatility would be high. In the case of a long holding period where the price is irrational, "the market can remain irrational longer than you can remain solvent" (Keynes). Shorting certain ETFs could lead to potentially infinite losses. However, you could also succeed, but I am not sure how you would systemize your trading. I believe in systems. If I believed in ETFs at all, I might buy a pair of opposing ETFs and adjust them to achieve a hedge objective - but I wouldn't because there are better options, and I don't like decay in any investment.

[tulog]

Not all ETFs are short term vehicles, there are some great index ETFs with very low expense ratios, a great alternative to mutual funds!

Some ETFs may be better than others. But I am not sure why you think they are great.

The best alternative to mutual funds is to buy common stock in the same proportions the fund would normally hold. That way you don't pay fees or taxes.

[jpg7n16]

Some ETFs may be better than others. But I am not sure why you think they are great.

The best alternative to mutual funds is to buy common stock in the same proportions the fund would normally hold. That way you don't pay fees or taxes.

You would get killed on commissions for your trades if you bought the same proportions as a mutual fund does. Unless you have the same amount of capital to work with.

Etrade $9.95/trade on common stocks

Mutual fund = 70 companies

You = out a lot of money

[tulog]

No. These costs are much less than management fees of any mutual fund.

It is best to use a broker with a pricing structure that allows you the choice per share trades (for small or medium orders) and flat commission trades (for large orders).

I agree that $9.95/trade is extremely overpriced. I pay $0.0003 a share commission, or $.95 a trade. Which pricing scheme I select is based on order size, generally I pay the 95 cents if I am ordering more than 3500 shares, or the per share amount for an order of fewer shares. I thus pay commission between 1 cent and 95 cents per order. This amounts to less than 0.005% of my trade amounts, including SEC fees. I am not aware of any mutual fund with a management fee or cost less than 0.005%. If you are aware of such a fund, please inform.

[jpg7n16]

E-Trade's pricing policies:

https://us.etrade.com/e/t/pricingandrates

Not sure where you are able to trade for such a low price.

I was able to find: TSX Markets Fee Schedule | TMX Group

...where you can trade for a similar low rate, but that ignores the $5k-50k setup charges, and $750-1500/month account maintenance fees.

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But regardless, there are several other issues with attempting to replicate your own mutual fund:
how do you account for $250/month additions without affecting diversification?
what if you can't buy partial shares?
how often are you going to rebalance?
do you know when the funds are exiting their positions?
do you have the time to go through all the research of new companies?
do you have the time to do all of the above?

[financebanter]

Re: ETF vs. Mutual Fund

You have to be very careful while using ETF as long-term investments. Because ETFs are short-term investments.

[jpg7n16]

You have to be very careful while using ETF as long-term investments. Because ETFs are short-term investments.

And by short term, you mean long term? How do you define long-term investment?

Long term is an investment with a time horizon of 5 years or greater - and ETF's can easily be held for 5+ years, and are usually recommended to do so. So why do you think they're short term?


If index funds and mutual funds are long term, then so are ETFs (Exchange-traded fund - Wikipedia, the free encyclopedia)

And if ETFs are short term, then so are mutual funds and index funds.

[disneysteve]

ETFs are short-term investments.

And if ETFs are short term, then so are mutual funds and index funds.

jpg, there seem to be a couple of people around here who use ETFs as trading instruments rather than as investments. Those folks don't seem to understand, though, that just because they trade them doesn't mean everybody trades them. As you point out, ETFs are no different than mutual funds. For that matter, they are no different than stocks. Just because some people buy a stock at 9am and sell it at 9:15am doesn't make the stock itself a short-term investment. It just means that person used it as a short-term investment. If I invest in an ETF and hold it until retirement in 20 years, poof, it is a long-term investment.

[tulog]

Steve, by long term investment, I mean an investment that because of its characteristics makes sense to hold long term. ETFs do not qualify because of decay and the other factors I mentioned. Not simply that a person decides to hold it long term. I could decide to purchase a piece of meat at the grocer and hold it 20 years, but that would not make it a long term investment. Just like an ETF, the piece of meat would decay and have less value.

ETFs are quite different than stocks. Stocks do not have decay. Thus you can hold stocks without losing the value of your investment for reasons only related to the passage of time.


When you purchase stock, you pay for the stock and bear ordinary market risk.

When you put money into an ETF, you pay for a portion of the asset value of the ETF, and each day you own the ETF you pay rent on the value of your investment in the form of decay, and you bear additional risk factors besides market risk.

[tulog]

In my opinion a good candidate for long term investment is that which has limited risk from time factors.
While both short term and long term investments have market risk, long term investments are more sensitive to time-based factors such as decay.

With an ETF you have an extreme amount of risk holding long term because you are making a bet that the investment return will exceed not only the ordinary market risks of the investment, but also the decay. This risk is too high, and more importantly the probability of a positive return is lower than other investments composed of the same holdings.