“One should avoid ETFs” vs. “ETFs can be used in a very active way”

In November we had a lively, knowledgeable group discussion on the value of the Total Expense Ratio (TER) as a measure and the pros and cons of Exchange Traded Funds (ETFs) vs. index funds. While our member ETF took the position of the ETF-defender, Alexarnback, who works professionally only with index funds, was a champion of index tracking mutual funds. It is worth reading the entire discussion.  As an appetizer, here’s an excerpt from the discussion and key arguments

Both of our members could agree that the TER is not the reflecting the total costs of a fund:

ETF: (…) Total Expense Ratio (TER) doesn't represent the total cost of owning a fund. Liquidity and total return are the key cost components to consider. 1. Total return An ETF's objective is to match the precise return of the fund's benchmark before the deduction of the TER (…) 2. Liquidity. In addition to the brokerage commission, the costs of liquidity for an investor are reflected by the size of the bid offer spread, the difference between the buying and selling price.of an ETF.

Alexarnback: TER is unfortunately not a good measure because you have to add many layers such as transactions, sec lending, friction of large sums coming in or out of the fund.(…) It depends on many factors such as the fund manager policy on sec lending(which is not directly a cost, however, an opportunity cost), portfolio turnover (depends on how the index is built).(…).

But had very different opinions on whether or not investors should go for ETFs or other index funds…

Alexarnback: I think one should avoid ETFs as much as possible and buy true passive funds (market funds) or index funds for the following reasons: 1. ETFs have many flaws (spreads, counterparty risk due to Swaps...) 2.An index is a limited way to see the market (i.e there are 75'000 listed securities in the world and the MSCI world only holds about 1'700 or 2.2% of the market).The index approach forces irrational behaviors such as lower diversification and buy high sell low.

ETF: In many cases ETFs' spreads can actually be tighter than the spreads of underlying stocks or bonds. 2. Counterparty risk can be avoided by choosing physical ETFs. 3. ETFs can be bought at NAV as well. 4. Securities lending revenues within ETFs are fully transparent since they are audited and declared in the annual accounts (…)Tracking an index does not necessarily mean following it blindly. Many wealth manager use ETFs in a very active way. The characteristics of ETFs make them easy to buy and sell, enter and exit the market when it suits.

…and whether investors should favour active or passive investment styles:

Alexarnback: (…) Since it is academically demonstrated that 98% of active managers do not beat the market after a 5 year period, why should anyone do active management? Except for the attraction of gambling.

ETF: Active funds can still deliver alpha over shorter periods of time than 5 year. Picking the right ones and blending them with ETFs does make sense.

Great insights and thanks for the contributions. Please check the full discussion.