The "ETF Oxymoron" was highlighted in my previous column when I looked at how the ETF structure actually is more beneficial for active management than for passive management. Taking that a step further, an interesting exercise would be to provide a specific example of how the ETF structure can better handle changes that typically accompany an actively managed strategy in regards to handling portfolio changes, turnover and rebalancing.
To illustrate that, let’s use a comparison of an index ETF and index mutual fund that both offer the exact same investment strategy run by the same portfolio management team. (I’m using that method because index ETFs have a much longer track record than more recently incepted active ETFs),
The Fidelity NASDAQ Composite Index Fund (FNCMX), a mutual fund, and the Fidelity NASDAQ Composite Index Tracking Stock ETF (ONEQ) are obviously both managed by Fidelity and follow the same investment strategy of tracking the performance of the NASDAQ Composite Index. It’s very important to note that Fidelity does an exemplary job in managing both these strategies, and this analysis is not intended to question Fidelity or the skill of their portfolio management team. Again, these examples are used because both funds follow the same investment strategy, and both are sizable products that follow an index with a reasonable amount of turnover. Let’s take a snapshot of performance comparison over the last four full years.
FNCMX ONEQ
2016 8.79% 8.81%
2015 6.82% 7.04%
2014 14.60% 14.67%
2013 39.75% 39.86%
Net Expense Ratio: 0.29% 0.21%
AUM (as of 9/29/17) $4.6B $1.3B
Holdings (as of 7/31/17): 2,158 1,003
The mutual fund and ETF compare very similarly for the most part in terms of their performance, net expense ratios, and both possessing over a billion dollars in assets under management. The most notable difference comes from the number of portfolio holdings, and the level of optimization that the portfolio manager utilizes to replicate the performance of the index. With 2,554 securities in the Nasdaq Composite, a portfolio manager can use optimization, which typically involves not investing in smaller securities that have a very small impact on the value of the index, and then increase the weighting to other securities in the index with a very high correlation to those securities not used.
All these factors combined can help account for the spread in performance, which ranged from two basis points to 22 basis points of outperformance by the ETF over the last four full years.
However, an even more noticeable difference exists between the fund distributions associated with changes in the index and the impact of flows. The following table displays the distribution averages over that last four-year span from 2013 to 2016.
FNCMX ONEQ
Total Distributions: $3.40 $8.00
Distribution Percentage: 5.94% 4.43%
(total annual distribution/
mid-year NAV)
Keep in mind any snapshot analysis measuring other timeframes could provide different results. The data cited here were sourced from Morningstar, Yahoo Finance and Fidelity’s website. To get a better feel for the differences, an advisor should view a desired snapshot over a reasonable holding period. The last four calendar years present a good example of how the different fund structures handled gains during a bull market. However, that same period also may not be reflective of a more balanced market environment where capital losses can offset capital gains.
The results over the four-year span show that the mutual fund paid out 151 basis points more in taxable distributions than the ETF structure. While that’s not all attributed to structural differences—one fund’s approach optimizes while the other fund’s approach appears not to optimize—clearly the ETF can handle portfolio changes far more efficiently. If someone assumes a 35% tax rate on the average annual distribution and the average performance difference, the cost of ownership almost doubles for the mutual fund version.