For years prospective clients have asked us why we generally prefer to utilize mutual funds over ETFs in the construction of client portfolios, given the extremely low expense ratios and broad asset class coverage of ETFs. For advisors who proselytize about diversification and the general efficiency of markets, as we do, ETFs would seem like the logical way to implement an asset allocation strategy. Antti Petajisto has been studying ETF markets for over a decade, and his research quantifies the hidden cost of trading on open exchanges, as ETFs do, rather than once a day at net asset value, as mutual funds do, in what he describes as “the first comprehensive study of the pricing efficiency of all US-listed ETFs after the dramatic surge in new products.”
While the research monograph is a rather technical analysis of market dynamics, Petajisto’s conclusion highlights the hidden drag that we have been explaining to our clients for years: the drag of transaction costs. He writes: “It is easy for an investor to fall into the trap of focusing so much on the expense ratios of funds that the transaction price for ETF shares is overlooked. Given that US ETF assets were about $2 trillion and growing in 2014, any nontrivial mispricing in ETFs has the potential to represent a considerable wealth transfer from less sophisticated individual investors to more sophisticated institutional investors.” We agree.