Chuck Jaffe: Market madness highlights fund/ETF differences

On May 6, as the market was going berserk, fund investors were in a strange position.

If you were nervous and thinking of selling, you were better off in a traditional mutual fund. If you were contrarian and looking to buy, you wanted exchange-traded funds.

The situation highlighted the difference between the two types of funds in ways most investors probably never considered before, but also showed precisely why someone might choose one form of fund or use both.

To see why that is, let's examine the different fund types, and the circumstances of May 6.

Open-end mutual funds and exchange-traded funds pool investor monies, providing a professional manager to follow a specific strategy. ETFs, typically, are focused on indexing — although there are more actively managed offerings all the time — while traditional funds focus more on active management (although there are plenty of index funds to choose from).

In traditional funds, all transactions are made at the next closing price. While a handful of funds are priced every hour, the standard deal is that if you sell in the middle of the trading day, your trade is executed at the net asset value at the end of the day. Traditional funds may carry short-term redemption fees — applied to investors getting out within up to a year of buying their shares — and may also carry sales charges on buys and sells.

ETFs, by comparison, are mutual funds that trade like stocks. They are priced minute-by-minute throughout the day; if you want in or out, you should get the market price the moment you pull the trigger. You pay commissions on trades, although some brokerages have brought trading costs all the way down to zero to encourage ETF action.

In both cases, you are looking at "mutual funds," and the differences tend to be a bit beneath the surface. In short, the ETF is built to be a trading vehicle, while the traditional fund is more of a "holding" vehicle. Since you could have an ETF and a traditional fund built on the exact same portfolio, those differences in mechanics — which extend to other concerns like taxes — truly make the difference in which form is "better" for any given individual.

Now fast forward to May 6. The Dow Jones industrial average lost 1,000 points, then recaptured 650 before the close. In one stretch, lasting roughly 15 minutes, the market first lost about 500 points, and then got it back.

If that action was making investors seasick and they wanted to sell their traditional mutual fund, they would have gotten the day's closing price, no matter their timing. They would not have been able to sidestep the decline, but they also could not panic out of the rebound.

With an ETF trade, however, they almost certainly got the worst-case scenario.

Many ETF investors set stop-loss limits — pre-scheduling a sale to protect profits if the share price drops to some predetermined level — but that didn't minimize their pain on May 6. The market busted a lot of those limit orders. They could not be executed at the shareholder's designated stop price because there were no buyers; thus the trades happened at lower prices, if at all. (Because it trades like a stock, an ETF must match buyers to sellers, where a traditional fund simply takes back outstanding shares as they are redeemed.)

"People put in stops to protect themselves, and then that protection didn't really work for them," said Karl Mills of Jurika, Mills & Keifer, an Oakland, Calif., money-management firm. "They took a huge hit because they didn't quite understand what could happen in an event of this magnitude, and their defensive strategy didn't work in this environment."

On the flip side, buyers who saw opportunity in the market free fall could only get their money into a traditional fund at the end of the day, but could become the ETF purchaser for some of those investors who were panicking out, getting their shares on the cheap in the heat of the battle.

Ultimately, the differences are about "friction," the cost, effort and timing involved in executing a trade. Jack Bogle, founder of the Vanguard Group and the patron saint of index investing, has long maintained that if you give an investor a trading vehicle — an ETF — they will eventually move it at just the wrong time, rather than staying put and capturing the long-term trend. Clearly, the market has now demonstrated how ETF investors can hurt themselves trying to get out of the way of a tidal wave.

"Theoretically, ... ETFs are great for investors, with low expenses, a better tax situation, and you can pick your spots to buy and sell," said Mark Salzinger, editor of the No-Load Fund Investor and the Investor's ETF Report newsletters. "But if you are an ordinary, average investor, your psychology matters. And with ETFs having less friction and no real disincentive to trading, you need to know that you can handle it, and not trade your way into mistakes while you think you are protecting yourself. ... [May 6] showed why you might want both; there's room in a portfolio for funds and ETFs."

Chuck Jaffe is a senior columnist

at MarketWatch.

He can be reached

at cjaffe@marketwatch.com.

or Box 70, Cohasset, MA 02025-0070.