Thanks for reading, Number 2. I did not even try to incorporate tax issues into the example, but you are very correct about the high degree of mutual fund distributions.

Quick note on REITs-
Just a quick follow up, REITs have destroyed the market for 7 years running (by more than 6% annualized). Low correlation to homebuilding (or your house), valuations primarily driven by macro trends such as interest rates (as an investment REITs are dividend plays and are also typically leveraged at 40-60%), rent growth, occupancy, population trends etc… In fact, recent housing downturn increased rents -when people stopped buying and decided to rent- driving up the multyfamily sector. Major downside of REITs is current valuations are also being driven by record capital flows into market. PE shops like Blackstone buying up hotels and office (like recent $36 Billion EOP buyout) keep driving up prices and limiting available public equity. Although there is no end in site to current demand, valuations are at historically high AFFO multiples (a proxy for cash flow that REIT investors use). However, you could say the same thing last year before the REITs returned 36%….

The ETF structure, for the most part, allows the big guys to really take advantage of any inconsistency in valuation or bid/ask. That keeps the valuations pretty tight, although with new, small ETFs, that problem might become more relevant.

Reinvesting dividends is a brokerage issue. E*Trade will reinvest dividends in ETFs for free, no commission. They treat it like a DRIP program. I have the Vanguard Small Cap Index (VB) set up this way, and it works just like a no load fund, but it’s an ETF.

Thanks for reading! I continue to eagerly await the next post on The Steinhorn Stare…

- Just like any stock, when buying or selling an ETF there is a bid/ask spread that may impact that real price you can buy or sell the fund for. So, if an identical mutual fund and ETF had an identical real-time price (let’s say, $x), the mutual fund could necessarily be bought for exactly $x, but the ETF would likely have a higher actual purchase price, due to the bid/ask spread. Likewise for the ETF sale. Generally, this spread is small (especially for ETFs which tend not to be as volatile as individual equities), but with large investments, the incremental loss due to spread can be non-trivial;

- Since ETFs are traded on the open exchange, you will often see situations where the ETF is trading at a discount or a premium to the actually value of the underlying investments (i.e., the price doesn’t necessarily track the NAV of the fund). As the market is pretty efficient, this discount/premium won’t generally be great, but again, when talking about small advantages/disadvantages compared to a mutual fund, these amounts may not be trivial, and shouldn’t be discounted in the analysis.

- Another issue that I’m not familiar with (but am very curious about) is how brokerages deal with dividends paid through ETFs. If they don’t reinvest the dividends (as mutual funds do), and the investor must pay additional commissions/fee to reinvest the dividends, this can have a tremendous impact on the long-term investment return of the instrument.

Of course, for more speculative investors, there are also additional benefits to ETFs:

- ETFs can be shorted ;

- ETFs can be bought on margin;

- ETFs can be traded throughout the day (as opposed to mutual funds that can only be purchased once/day, at the closing price of the fund).

Jason