New clients at Telarray are offered a session at the beginning of our relationship to discuss the Telarray approach to investing. It’s a lot to process in an hour or two, and we know that there may be questions as our relationship develops.
Of course, you may call your Advisor at any time with any of your questions, but we thought a multi-part series discussing our approach to investing might be helpful, too. Today is the second part of this series, in which we discuss how we actually get exposure to markets in Telarray portfolios.
We intend, eventually, to make the entire series available to our clients, both immediately following the initial investment session and also down the road as a resource available on demand.
At Telarray, we don’t buy stocks and bonds directly. It would be inefficient to build out the research capability within our firm to select stocks and bonds across countless sectors and countries. Though unlike many firms our size, we have a team with expertise sufficient to implement almost any institutional-quality strategy, no firm has the capacity to do them all successfully. Therefore, we spend a great deal of time selecting our funds and fund providers rather than focusing on individual companies and securities.
Sometimes clients ask us to direct them to hot stocks in accounts they control themselves, but we don’t do this under any circumstances. Our belief is that stock picking accounts are either too small to have a material impact on wealth or too risky if they’re large enough to move the needle. All clients benefit by our investment team sticking to what’s important and focusing on building the best diversified portfolios we can rather than giving out hot tips. Though FOMO (fear of missing out) is ever-present, investing is a marathon, not a sprint.
Regular mutual funds are baskets of stocks or bonds managed by professionals toward a specific goal. These funds can easily be identified by their five letter ticker symbols, ending in X (for example, ABCDX). Each day, investors buy and sell shares in these funds through the fund sponsor at a single price that is struck each afternoon based on the value of the positions in the portfolio. This price is designed to be fair to buyers and sellers, as it exactly values the holdings of the fund to the extent possible.
A benefit of regular mutual funds is that they have no bid-ask spread, meaning investors buy and sell shares at the exact same price. One downside is that they tend to experience capital gain distributions, which means some taxes are assessed on the fund earlier than would be ideal even if investors aren’t selling shares. Our fund providers make trading choices that tend to minimize the magnitude of these distributions. Another disadvantage is that mutual funds have a transaction fee at custodians like Schwab to buy or sell, but the fee is small and, given our infrequent trading, transaction fees are not a material cost in typical Telarray portfolio.
ETFs — exchange traded funds — have gotten a lot of press these days, due to clever marketing from prominent sponsors. ETFs are just like mutual funds in most ways (unlike five-letter mutual fund symbols, ETFs have two- to four-letter symbols). The main difference is that ETFs are bought and sold on stock exchanges just like stocks, while traditional mutual funds are not.
ETFs tend to have lower fees than mutual funds, but our providers tend to offer the fund and ETF versions at the same cost when both are available, so this isn’t important to our portfolios. A real advantage of ETFs is that capital gain distributions are very rare due to the way shares are created behind the scenes.
A disadvantage of ETFs is that since they are exchange traded, there is a bid-ask spread. This means that, unlike mutual funds that have one price every day, ETFs have a higher price for buying and a lower price for selling at any given moment. Also, when conducting large rebalances, it’s possible that the trading volume required in our funds could cause market impact. In other words, our buying and selling could drive the price away from the NAV, or value of all the ETF’s holdings. If that happened, we might be buying at an increasingly higher price or selling at a lower price than the true underlying value of the fund.
At this time, we are ambivalent on the question of ETFs vs. mutual funds. When available, our providers tend to offer mutual funds and ETFs at the same or very similar cost to investors. The biggest downside to mutual funds is potential capital gain distributions, but with ETFs, the trading impact and bid-ask spread mean ETFs are not necessarily better.
We tend to use mutual funds for our clients because we believe minimizing market impact is the most important consideration. This could change as trading volume of ETFs increases. Our T2 strategy is exclusively implemented using ETFs, in part so that we match the approach we tested when we developed the strategy initially. You may even see a mutual fund and an ETF version of the same fund in your portfolio for various reasons, including tax loss harvesting.
Over time, we will likely shift along with the industry toward more ETFs, but there’s no rush. For a typical investor, we believe the difference between investing in a comparable fund and ETF is not material. What’s in the funds is much more important than their wrapper.
Coming up in Part 3: A discussion of the types of accounts we use to hold investments at Telarray and how we put these pieces together to build your portfolio.