Are Mutual Funds "Safer" Than ETFs?
Posted: Sun Aug 05, 2012 7:14 am
With the Knight Capital fiasco of last week, it got me thinking about Mutual Funds vs ETFs again.
One theory, based on pure speculation, that I've held for a while is that Mutual Funds are safer than ETFs, because they have been around longer and only trade once per day. For purposes of this discussion, I will refer to Stock funds because in the purest PP, gold, cash and bonds should be held directly. However, I'd guess ETFs may only trade their underlying assets once per day too.
It's possible in my mind that there's some weird ETF framework in place that hasn't been a problem yet, but a high speed trading issue may trigger "something bad" whereas mutual funds have been around for a long time so we'd know they are structured in a "safer" way.
I used to like the idea of splitting my stocks between Mutual Funds and ETFs to hedge my bet and also to allow for intra-day rebalancing if necessary. However, when I really thought about it, it didn't make sense. If the stock market dropped 50% intra-day, then holding easily-tradable ETFs wouldn't be a benefit because the PP says I should sell another asset and buy more stocks. I don't need to hold ETFs leading up to a crash. I can simply sell my treasury bonds on the afternoon of the crash and immediately buy stock ETFs. (because the market may settle after hours and I want to lock in the low stock price).
I also feel that holding the mutual fund directly by the fund company (i.e. holding a Vanguard Mutual Fund in a Vanguard Account) is "safer" than holding an ETF in a brokerage account. Harry Brown always talks of reducing the layers between you and your money. In theory, an ETF in a brokerage account is another layer. Even if you hold a VG ETF in a VG Brokerage account, VG has a "weird" structure in place that separates its brokerage entity from it's mutual fund company to meet some legal requirements.
I think if a catastrophe happened, then holding the mutual fund directly will better ensure I am made whole in the end, because the mutual fund company maintains records of the share holders. On the flip side, it's possible that each mutual fund has its own IT system that might be a crapshoot as to how well it holds up compared to a brokerage in the event of a catastrophic global IT failure. But if we're talking about the really big mutual funds like VGs TSM fund that has a metric buttload of assets, I imagine they will be able to figure out who owned what. Also if the systems did go down, in theory it would be easier to rebuild the database of an individual mutual fund rather than a brokerage because a mutual fund would have 2 main entries (name of client and number of shares) whereas a brokerage requires 3 (name of client, number of shares, ID of the security - because the mutual fund only trades a single security and doesn't need this third piece of data).
I understand that Mutual Funds are a little more expensive than ETFs in the expense ratio realm, and this is due almost entirely to the internal reporting/account maintenance requirements that mutual funds have. i.e. it costs money for them to maintain a log of shareholders and directly mail out paperwork, as opposed to an ETF that has a 3rd party brokerage do it for them (and the brokerage gets compensated for this effort through the trading spread of the ETF and commissions on sales).
I feel like an old man shaking my broom in the air to the ETFs to get off my lawn. How does my logic hold up to reality?
One theory, based on pure speculation, that I've held for a while is that Mutual Funds are safer than ETFs, because they have been around longer and only trade once per day. For purposes of this discussion, I will refer to Stock funds because in the purest PP, gold, cash and bonds should be held directly. However, I'd guess ETFs may only trade their underlying assets once per day too.
It's possible in my mind that there's some weird ETF framework in place that hasn't been a problem yet, but a high speed trading issue may trigger "something bad" whereas mutual funds have been around for a long time so we'd know they are structured in a "safer" way.
I used to like the idea of splitting my stocks between Mutual Funds and ETFs to hedge my bet and also to allow for intra-day rebalancing if necessary. However, when I really thought about it, it didn't make sense. If the stock market dropped 50% intra-day, then holding easily-tradable ETFs wouldn't be a benefit because the PP says I should sell another asset and buy more stocks. I don't need to hold ETFs leading up to a crash. I can simply sell my treasury bonds on the afternoon of the crash and immediately buy stock ETFs. (because the market may settle after hours and I want to lock in the low stock price).
I also feel that holding the mutual fund directly by the fund company (i.e. holding a Vanguard Mutual Fund in a Vanguard Account) is "safer" than holding an ETF in a brokerage account. Harry Brown always talks of reducing the layers between you and your money. In theory, an ETF in a brokerage account is another layer. Even if you hold a VG ETF in a VG Brokerage account, VG has a "weird" structure in place that separates its brokerage entity from it's mutual fund company to meet some legal requirements.
I think if a catastrophe happened, then holding the mutual fund directly will better ensure I am made whole in the end, because the mutual fund company maintains records of the share holders. On the flip side, it's possible that each mutual fund has its own IT system that might be a crapshoot as to how well it holds up compared to a brokerage in the event of a catastrophic global IT failure. But if we're talking about the really big mutual funds like VGs TSM fund that has a metric buttload of assets, I imagine they will be able to figure out who owned what. Also if the systems did go down, in theory it would be easier to rebuild the database of an individual mutual fund rather than a brokerage because a mutual fund would have 2 main entries (name of client and number of shares) whereas a brokerage requires 3 (name of client, number of shares, ID of the security - because the mutual fund only trades a single security and doesn't need this third piece of data).
I understand that Mutual Funds are a little more expensive than ETFs in the expense ratio realm, and this is due almost entirely to the internal reporting/account maintenance requirements that mutual funds have. i.e. it costs money for them to maintain a log of shareholders and directly mail out paperwork, as opposed to an ETF that has a 3rd party brokerage do it for them (and the brokerage gets compensated for this effort through the trading spread of the ETF and commissions on sales).
I feel like an old man shaking my broom in the air to the ETFs to get off my lawn. How does my logic hold up to reality?
