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Exchange Traded Funds (ETFs) were first introduced in 1993 for institutional investors. They have since become increasingly acceptable to advisors and investors alike due to their ability to allow portfolio construction at a lower cost and greater control over the diversification process. You should consider making them a core building block for the foundation of your personal investment portfolio.
1. Better Diversification: Most individuals do not have the time or skills to follow every stock or asset class. Essentially, this means that an individual will gravitate toward the sector he or she is most comfortable with, which can result in investing in a limited number of stocks or bonds within a single business or industry sector. Think of a telecom engineer at Lucent who bought stocks like AT&T, Global Crossing or WorldCom. Using an ETF to buy a lead position in the market as a whole or in a specific sector provides instant diversification that reduces portfolio risk.
2. better performance: Research and experience have shown that most actively managed mutual funds generally underperform their benchmark indexes. With fewer instruments, limited access to institutional research and a lack of a disciplined buy/sell strategy, most individual investors tend to perform worse. Without worrying about picking individual winners or losers in a sector, an investor can invest in a basket of broad-based ETFs for core holdings and be able to improve the overall performance of the portfolio. For example, the Consumer Staples Select Sector SPDR was down 15% as of October 23, 2008 while the S&P 500 was down over 38%.
3. More Transparency: More than 60% of Americans invest through mutual funds. Yet most investors don’t really know what they have in store. Except for a quarterly report that shows holdings as of the close of trading on the last day of the quarter, mutual fund investors don’t really know what is in their portfolios. An ETF is completely transparent. An investor knows what is involved in the entire trading day. And pricing for an ETF is available throughout the day, compared to a mutual fund, which trades at the closing price of the business day.
4. No Style Drift: While mutual funds profess a certain orientation such as large cap or small cap stocks or growth versus value, it is common for a portfolio manager to move away from the core strategy outlined in the prospectus in an effort to boost returns. An active fund manager may add other stocks or bonds that may add to returns or lower risk but are not in the same sector, market cap or style as the core portfolio. Essentially, this can result in an investor owning multiple mutual funds with overlap exposure to a specific company or sector.
5. Easy Rebalancing: The financial media often extol the virtues of rebalancing a portfolio. Nevertheless, it is sometimes easier said than done. Because most mutual funds hold a combination of cash and securities and may include a mix of large cap, small cap or even value and growth type stocks, it is important to properly rebalance the targeted asset allocation mix. Precise analysis is difficult. Since each ETF typically represents a specific asset class, industry sector, or index of market capitalization, an asset allocation strategy is very easy to implement. Let’s say you want a 50/50 portfolio between cash and a total US stock market index. If the value of the S&P 500 (represented by the SPDR S&P 500 ETF ‘SPY’) fell 10%, you could move 10% from cash to return to the target allocation.
6. More tax efficient: Unlike a mutual fund, which has embedded capital gains created by past trading activity, an ETF has no gains that compel an investor to recognize income. When an ETF is purchased, it establishes a cost basis for the investor to invest on that particular trade. And given the fact that most ETFs follow a low-turnover, buy-and-hold approach, many ETFs will be highly tax efficient with no realized gains or losses to individual shareholders. Only When they actually sell their ETFs.
7. Low Transaction Cost: Operating an ETF is much cheaper than a mutual fund. In mutual funds, there are shareholder service expenses that are not required for ETFs. Furthermore, ETFs eliminate the need for research and portfolio management since most ETFs follow a passive index approach. ETFs mirror the benchmark index and there is no need for additional expenses of portfolio analysts. This is why the average ETF’s internal expenses range from 0.18% to 0.58%, while the average actively managed mutual fund averages around 1.5% in annual expenses and trading costs.
To compare the total cost of holding an ETF with that of a mutual fund, the Financial Industry Regulatory Authority (FINRA) provides a Fund and ETF Analyzer tool on its website. The calculator automatically provides fee and expense data for all fund share classes and ETFs. The calculator can be found here: http://apps.finra.org/fundanalyzer/1/fa.aspx,
8. Flexibility in trading and implementing sophisticated investment strategies: ETFs trade like other stocks and bonds. So this means that an investor has the flexibility to use them to employ a range of risk management and trading strategies, including hedging techniques such as “stop loss” and “shorting.” Option “long-only” mutual funds. Not available by
Another advantage is the ability to use “inverse ETFs” which can provide some protection against declines in market or sector value. (An inverse ETF reacts inversely to the return of the underlying benchmark. So if one wants to reduce the effect of a decline in the S&P 500 index, for example, it can invest a portion of the portfolio in “inverse” up when the index price goes down.)
Or an investor can tilt his portfolio to “overweight” a particular industry or sector by buying more ETF indexes for that sector. By purchasing an index, an investor can be positioned to take advantage of expected changes in the industry or sector without the inherent risks of any individual stock.
Some investors get attached to their individual stocks or mutual funds and don’t want to sell and take a loss and miss out on the expected rebound opportunity. Another tax-efficient option for an investor to consider is to sell a security that is at a loss while purchasing an ETF that represents the industry or sector of the security sold. This way the investor can book a loss, take a tax deduction for it and still be positioned in the sector but with a more widely diversified index.
Investors, academics and financial advisors sometimes question the “buy and hold” strategy. Some investors want a more active management strategic approach that can be done with ETFs. Even though ETFs represent passively constructed indexes, an investor can actively trade them. There are a variety of trading strategies available to “manage the trend”. When an index moves above or below its 50-day moving average or 200-day moving average, it can be a signal to trade in or out of the ETF. To reduce the trading costs incurred from trading ETFs, an investor can use an ETF wrap program that covers all trading costs. Typically, this type of arrangement is still less expensive than buying or selling many individual stocks in a separate managed account or using an actively managed mutual fund.
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