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Posts Tagged ‘buy and hold’

What could possibly link the children’s story of Watership Down, Thanksgiving turkey and retirement investing risks?

Well, my mind works in strange ways (just ask my wife and I’m sure my 15-month old Spencer agrees as well).

Buy and Hold – A Broken Promise?

After all the troubles in the stock market and in financial markets in general over the past couple of years, I was recently rereading an article in the trade magazine, Journal of Financial Planning. In the September 2009 issue there is a book excerpt by Ken Solow, CFP (R) entitled Buy and Hold is Dead (AGAIN): The Trouble with Quant Models.

Over the past couple of years there has been much written about Buy and Hold investing. You may be familiar with the concept as an approach to investing that focuses on selecting an investment (stocks, bonds, mutual funds, real estate) and simply holding on through good times and bad.  Occasionally, you should rebalance back toward some strategic assert allocation to reduce or minimize certain risks.

The reasoning behind this is simple: humans are bad at financial decisions and by adopting this approach you can take the emotion out of investing.  Too often, we tend to make important decisions with little information and rely on emotions like fear or greed.  In fact, Warren Buffet, investor-extraordinaire of Berkshire-Hathaway fame, has said this many times and by doing the opposite of what the masses do he has amassed a fortune for himself and his investors.

For many, buy and hold was discredited after the great Financial Meltdown that tipped us into the Great Recession.  All asset  classes – whether large company stocks, small company stocks, stocks of foreign firms, bonds from companies large or small and bonds issued by sovereign nations – went down.

Most investors feel cheated, angry and worse. This buy and hold approach was advertised as a way to minimize risk.  Unfortunately, most investors probably misinterpreted the idea of minimizing risk and thought that it eliminated the downside volatility.

As I often say to clients, we know there will be sunny days and rainy days.  Risk management means carrying an umbrella and maybe wearing a rain coat as well.  But just because you are using one or both of them doesn’t mean that you won’t get wet.  You’ll just not get soaked like the guy who’s running from the street curb toward the office door with nothing but a newspaper over his head.

It’s true that Buy and Hold will help take the emotion out of investing. Over the long-term, the Ibbotson Charts will show that all asset classes have gone up since 1926 until now even after the meltdown.

That provides cold comfort to the retiree who is just about to start withdrawals from his portfolio to supplement his retirement income and lifestyle.  There were many who saw their investments drop 30%, 40% or more.  And while their portfolio may have bounced back some with the market rally and over time the market may continue to rise, they just don’t have the time to wait.  They have to start taking out money now.  And each time they take out money to live on, there is less in the pot to grow.

This has happened before.  Remember Enron.  Remember Lucent Technologies.  On one day someone is a paper millionaire.  Fast forward and the companies are in the tank (bankrupt in the case of Enron) and your retirement dream is a nightmare. If you’re at the tail end of a 25 year career, you really don’t have the time to make it up but have to make do with what you have. (Even for these folks, not all is lost and there are things one can do to sustain a retirement as I noted here in a previous post. And I’ll be talking about sustainable withdrawal rates in another post on retirement income planning.)

For the rest of us, there is a lesson in there. And this is where Watership Down and Thanksgiving turkey come into play.

Buy and Hold, Modern Portfolio Theory & The Illusion of Math

Buy and Hold is based on the quantitative model of Modern Portfolio Theory (MPT) first devised Harry Markowitz more than 50 years ago.  Such quantitative models are based on lots of mathematics.  The formulas are complex and elegant.  They are beyond what most of us are comfortable with but they do provide a sense of security.  You input numbers from data on various asset classes and a very precise number comes out the other side of the black box.  This provides a sense of security.  Instead of relying on something subjective like your instinct or your gut feelings, you can put your faith into something objective like the science of math and finance.

Over the past few years and principally from the mid-1990s until our recent meltdown, we have come to rely on ever more complex quantitative models. These complex models drove the markets in real estate and mortgages as we relied more and more on the black boxes of the financial engineers.  But theories are only theories and models are only as good as the assumptions and data used to create them.

A chain is only as strong as its weakest link.  And a model is only as good as the assumptions behind it.  All models are based on past events. And even though we are warned that “past performance is no guarantee of future results” we rely on these backward-looking, statistically-based models for predicting our futures.

In a normal world, the behavior of markets and investors can be assumed pretty well. But in panics, all bets are off.  No amount of modeling can predict how presumably reasonable people will act but it’s safe to say that human nature’s fight or flight syndrome kicks in hard.

Watership Down – A Lesson from Spencer’s Bedtime

What happens is that things go along and work until they don’t.  Assumptions are assumed to be fine until they need to be revised. When I was reading Watership Down there is a scene where the protagonist, a wild rabbit, encounters a number of other well-fed white rabbits.  Our hero tries to get them to follow him but to no avail.  The tame rabbits live in a fine world where they are provided plenty of food, water, shelter and care.  What more is there to go searching for “out there?”

The Thanksgiving Turkey

Our false sense of security and belief in a system like MPT or Buy and Hold can be illustrated in the tale of the Thanksgiving turkey.

As retold by Nassim Taleb in The Black Swan:

Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey:  It will incur a revision of belief.

Unable or unwilling to question its beliefs, the turkey was lulled into a false sense of security by his daily reinforcing experiences. Like the tame white rabbits in Watership Down, the turkey’s world is looking good and life is great.  So much so that neither even think about ways to escape.

At least in the animated movie Chicken Run with Mel Gibson (another soon-to-be Spencer favorite), the chickens are led to question their assumptions about life on the farm and plot ways to escape.

What We Learn from Bedtime Stories for Investing

What we learn from these stories is that just because things have worked in the past, doesn’t mean that they are absolute truths that will hold in the future. The most dangerous thing that an investor can do is simply accept with blind faith the assumptions of the past.  In a changing market, there’s nothing scarier than conventional thinking.

Theories are only theories and while it may seem like heresy to question assumptions, it’s in your best interest to do so.

Does this mean abandoning Modern Portfolio Theory or Buy and Hold? No.

It does mean that it makes sense to add some human judgment to the mix.  Good models can work even better with common sense.

Like the counter-culture of the 1960s would teach, you as an investor will do best to question authority and question assumptions.

Use an Investment Policy Statement as a Better Road Map

Here with the aid of a qualified professional you can walk through and create a personalized investment policy statement as a road map for investing decisions.

Such an approach can combine the quantitative tools to be used along with the more qualitative, value-based criteria that can be combined to help in the investment selection and portfolio management process.

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Whatever your retirement dreams, they can still be made a reality.  It just depends on how you plan and manage your resources. On any journey it helps to have an idea where you’re going, how you plan to travel and what you want to do when you get there.

If this sounds like a vacation, well, it should. Most people invest more time planning a vacation than something like retirement.  And if you think of retirement as the Next Act in your life and approach it properly, you won’t be so easily bored or run out of money to continue the journey or get lost and make poor money decisions along the way.

It’s How You Manage It That Counts

How much you need really depends on the lifestyle you expect to have.  And it’s not necessarily true that your expenses drop in retirement. Assuming you have an idea of what your annual expenses might be in today’s dollars, you now have a target to shoot for in your planning and investing.

Add up the income from the sources you expect in retirement.  This can include Social Security benefits (the system is solvent for at least 25 years), any pensions (if you’re lucky to have such an employer-sponsored plan) and any income from jobs or that new career.

Endowment Spending: Pretend You’re Like Harvard or Yale

Consider adopting the same approach that keeps large organizations and endowments running.  They plan on being around a long time so they target a spending rate that allows the organization to sustain itself.

1. Figure Out Your Gap:  Take your budget, subtract the expected income sources and use the result as your target for your withdrawals. Keep this number at no more than 4%-5% of your total investment portfolio.

2. Use a Blended Approach: Each year look at increasing or decreasing your withdrawals based on 90% of the prior year rate and 10% on the investment portfolio’s performance.  If it goes up, you get a raise.  If investment values go down, you have to tighten your belt.  This works well in times of inflation to help you maintain your lifestyle.

3. Stay Invested:  You may feel tempted to bail from the stock market.  But despite the roller coaster we’ve had, it is still prudent to have a portion allocated to equities.  Considering that people are living longer, you may want to use this rule of thumb for your allocation to stocks: 128 minus your age.

If you think that the stock market is scary because it is prone to periods of wild swings, consider the risk that inflation will have on your buying power.  Bonds and CDs alone historically do not keep pace with inflation and only investments in equities have demonstrated this capability.

But invest smart. While asset allocation makes sense, you don’t have to be wedded to “buy-and-hold” and accept being bounced around like a yo-yo.  Your core allocation can be supplemented with more tactical or defensive investments.  And you can change up the mix of equities to dampen the roller coaster effects.  Consider including equities from large companies that pay dividends.  And add asset classes that are not tied to the ups and downs of the major market indexes.  These alternatives will change over time but the defensive ring around your core should be reevaluated from time to time to add things like commodities (oil, agriculture products), commodity producers (mining companies), distribution companies (pipelines), convertible bonds and managed futures.

4. Invest for Income: Don’t rely simply on bonds which have their own set of risks compared to stocks. (Think credit default risk or the impact of higher interest rates on your bond’s fixed income coupon).

Mix up your bond holdings to take advantage of the different characteristics that different types of bonds have. To protect against the negative impact of higher interest rates, consider corporate floating rate notes or a mutual fund that includes them.  By adding Hi-Yield bonds to the mix you’ll also provide some protection against eventual higher interest rates. While called junk bonds for a reason, they may not be as risky as one might think at first glance. Add Treasury Inflation Protected Securities (TIPS) that are backed by the full faith and credit of the US government.  Add in the bonds from emerging countries.  While there is currency risk, many of these countries do not have the same structural deficit or economic issues that the US and developed countries have.  Many learned their lessons from the debt crises of the late 1990s and did not invest in the exotic bonds created by financial engineers on Wall Street.

Include dividend-paying stocks or stock mutual funds in your mix.  Large foreign firms are great sources of dividends. Unlike the US, there are more companies in Europe that tend to pay out dividends. And they pay out monthly instead of quarterly like here in the US.  Balance this out with hybrid investments like convertible bonds that pay interest and offer upside appreciation.

5. Build a Safety Net: To sleep well at night use a bucket approach dipping into the investment bucket to refill the reserve that should have 2 years of expenses in near cash investments: savings, laddered CDs and fixed annuities.

Yes, I did say annuities.  This safety net is supported by three legs so you’re not putting all your eggs into annuities much less all into an annuity of a certain term. For many this may be a dirty word.  But the best way to sleep well at night is to know that your “must have” expenses are covered.  You can get relatively low cost fixed annuities without all the bells, whistles and complexity of other types of annuities.  (While tempting, I would tend to pass on “bonus” annuities because of the long schedule of surrender charges). You can stagger their terms (1-year, 2-year, 3-year and 5-year) just like CDs.  To minimize exposure to any one insurer, you should also consider spreading them around to more than one well-rated insurance carrier.

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After the Dow Industrials reached their peak on October 9, 2007, there was a long, painful decline to the trough reached on March 9, 2009.  During that time the DJIA lost 54% but was followed by a rally of 70%. Even with this spectacular run up through 2009, the index never reached it peak. While closer now after a good 2010 it, the peak is still a long climb up the mountain.  In fact, to break even from a 50+% loss requires a disproportionate increase (more than 100%) just to “get back to where you once belonged” as the classic rock song lyrics said.

Investors Win By Not Losing

As this roller coaster shows, its easier to keep what you have than try to rebuild it.  Unfortunately, after such volatility, investors tend to flee to places that are perceived to be safe.  For most that has created a flight to bonds. While investors think of risk as “loss of capital” the traditional views of risk continue to be turned on their head. Sure, you could stash your money away in a money market or under the mattress but what kind of return will that produce?  Will you have enough to eat more than dog food in retirement?

A recent documentary on the disaster at Pompeii and Herculaneum shows how many townspeople fled to the concrete tunnels near the wharves.  Considered a safe place, it ended up as a tomb to more than 300 skeletal remains. These hopeful survivors were trapped by the lava flows which sealed up the tunnels where they had fled.

In many ways, investors fleeing the danger of the markets by shifting to government bonds could be dooming themselves to a similar fate as the Pompeians.

The returns from “safe” Treasuries are pathetic.  Huge investor appetite has driven up to demand and helped lower the yields offered.  A backlash could hurt investors when interest rates rise as they inevitably have to.

If the goal is to preserve capital and avoid dangers, it shouldn’t matter to an investor what asset class is used.  (It’s Halloween.  Watch any scary movie and when the hapless victim is trapped he/she could care less whether the guy in the hockey mask is stopped by a dump truck or an arrow).

In much the same way, we should be looking at other ways to conserve capital.

Carrying Junk Around

Say “junk bonds” to someone and they may be thinking about Michael Milken in the 1980s or businesses on the brink of bankruptcy.  While these bonds are issued by companies with lower credit ratings, they offer a very good alternative to “safe” Government bonds. The point of diversification is to not put all your eggs in one basket.  Today most investors are torn between a savings account paying practically no interest or reaching for yield using alternatives.

The bond market prices the risks of bonds every day.  Currently, the bond market is pricing in a possibility of 6% default risk on junk bonds as a group.  That’s down from its historic number. Some individual bonds of companies may certainly be higher but as a group that’s not a bad number.  Some analysts at JP Morgan Chase have even estimated that the default risk for 2011 is as low as 1.4%.

Why so low? The projected default risk is low in part because companies are showing their highest level of profits in years.  They have shed workers, squeezed productivity gains from those remaining and taken over market share as weaker competitors have failed. The prospects for these companies look even better considering that as a recession ends company cash flows improve.  This means more cash available to service debt. And as these companies improve so too will their credit ratings leading to lower interest rates that they can get when they refinance their debts just like any homeowner would who has an improved credit score.

Avoiding the Danger of a Secular Bear

In a secular bear market, there are rally periods while the markets as a whole may languish or sometimes drop.  During the secular bear from 1/1/1965 to 12/31/1985, a Buy and Hold bond investor would have been whipsawed but ending up gaining about 1 basis point (or 0.01%)  per year for 20 years.  Not a lot of payback for the sometimes stomach-churning ride over that time.

A More Tactical Approach to Risk Management

Not all bonds are the same.  There are government bonds, municipal bonds, US investment grade corporate bonds, US hi-yield/junk bonds, convertible bonds, bonds from overseas and bonds from emerging markets.  Just like every homeowner applying for a mortgage is different and has to go through different underwriting,  the characteristics of all these bonds are different as well.

For instance, hi-yield bonds are more likely subject to credit risk.  Since the rates on these types of bonds are higher than that found on a Government bond or investment grade corporate bond, they are not so sensitive to changes in interest rates.  On the other hand, Government bonds are more sensitive to interest rate risk and the perceptions about expected inflation or the impact of monetary and fiscal policy on future interest rates.

Since these two bond categories are influenced by different factors, they tend to not be correlated meaning that they don’t move in lock-step: When one is zigging the other is probably zagging in the opposite direction.

A key way to reduce risk and potentially increase returns when dealing with bonds is to rotate among the different bond types.  Sometimes the market conditions favor one flavor of bonds over another.  At other times it’s better to reduce all bond types and shift to cash or money markets.

Simply buying and holding means that gains made in one period may be taken away by another. If you’re able to make gains and take them off the table from time to time, you’ll have less money at risk and greater opportunities at preserving capital for the long term.

In the chart below, you can see that buying each of these major bond indexes can produce widely different results.  For nearly the same risk level (as measured by the standard deviation), US High Yield long term bonds have a clearly higher overall return and higher return during periods of higher interest rates than the long-term US Treasury index.

Bottom Line

Investors seeking ways to add income to their portfolio and reduce risk of loss to their capital really need to consider alternatives to buying and holding.  Rotating among these different bond asset types may reduce the overall volatility to the portfolio and preserve capital for the long term.

If you don’t want to end up like the victims of Mount Vesuvius and be buried by a “safe” move, you should open your minds to understand all the risks and ways to manage them.

Figure 1 (Source: BTS Asset Management Presentation/Nataxis Global Assoc, 10/27/2010)

Bond Index Annualized ReturnNov 1992 – Aug 2009 Standard Deviation (measure of risk) Annual Return During Rising Rate Period
BarCap US High Yield Long 10.45% 10.94 6.75%
BarCap US Corp Baa Investment Grade 6.97% 6.31 1.75%
BarCap US Aggregate Bond 6.46% 3.82 1.31%
BarCap LT US Treasury 8.11% 9.28 -0.40%

Figure 2 (Source: BTS Asset Management Presentation, 10/27/2010)

Bond Sector Credit Risk Interest Rate Risk Currency Risk
US High Yield High Low None
International Developed Market Low Medium High
Long-term US Government None High None
Emerging Market High Low High
US Municipal Low High None
US Investment Grade Corporate Low High None

Figure 3 (Source: BTS Asset Management Presentation, 10/27/2010)

CAPITAL PRESERVATION KEY to LONG-TERM SUCCESS
Loss Gain Needed to Get Back to Break Even

(15%)

+ 18%

(20%)

+ 25%

(30%) + 43%

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“Sometimes all it takes to change your life massively for the better is a small action and a small success, “ says David Bach, a noted author on money matters. 

  1. Consolidate Your Accounts:  Don’t wait for spring cleaning to roll around.  Make it easier on yourself by combining old 401(k) or IRA balances from your various old jobs.  This can help cut down on the amount of paper you receive and improve the chances you’ll have a coordinated investment plan. And it’s just one more way to have a more ‘green’ holiday.
  2. Pay Yourself First: While there always seems like there’s more month at the end of your paycheck, you can only get ahead by making a point of putting aside money in savings.  It doesn’t matter if it’s just $5 or 5% of each paycheck as long as it’s consistent.  Start somewhere and try to build up to your target of at least 5% of your net cash flow. Direct the money into a separate money market account that you can’t access easily from an ATM or debit card.
  3. Get to Know Where Your Money Goes:  For most people cash flow is not the problem. It’s cash retention that is a challenge. There always seems to be too much flow away from you.  Set up a system to keep track of where your money is spent.  Whether you decide to use a notebook or financial accounting software like Quicken or an online service like Mint.com, this is a first step to getting the information you need to decide what your spending priorities should be. 
  4. Cut Expenses:  Armed with the information from your tracking, now consider ways to lower expenses.  Do you really need a daily Mucho Grande from your favorite coffee place?  At $5 a day, your habit could help pay for your annual vacation or pay down your credit card or mortgage debt. Do you really use all those movie channels?  Can you wear a sweater and lower the thermostat?  Do you really need to be in the mall? Cut down on impulse shopping by creating and sticking to a master list of groceries and household goods.
  5. Reduce Temptation: Consider saving the bulk of any bonus checks or raises.  By automatically diverting this money, you’ll be able to add to your emergency stash, have cash to pay down debt or even invest. See #2 above.
  6. Reevaluate Your Risk Tolerance:  One of the most useful services that financial planners can offer is helping you really articulate your goals and establish your tolerance for investing risk.  After the bumpy ride of the past 18 months, most folks realize that they may not have had a handle on this.
  7. Avoid the Casino Mentality: It is an understatement that investing in the market can be risky but now is not the time to try to play catch up by “doubling down” or chasing the hottest investments ideas.  Remember the story of the tortoise and hare.  Sometimes the race doesn’t go to the swiftest but the most consistent.  So diversify your eggs into different baskets and watch those baskets.  For help in choosing the right mix of investments and a style that will help you sleep better at night, consider meeting with a CERTIFIED FINANCIAL PLANNER ™ professional.
  8. Rebalance Your Investments:  Over time, accounts that have been consistently rebalanced tend to have higher balances.  So plan to rebalance at least annually or even quarterly.  But first you need to have targets in mind so that you can unemotionally prune back your winners while adding to the laggards.
  9. Add to Your Retirement:  If you haven’t taken advantage of your employer’s sponsored retirement plan, start now.  If your employer doesn’t offer a plan or you’re self-employed, start your own.  Resolve to set aside at least the amount that will get you the maximum company match.   Ideally, you should know your “NUMBER” for living in retirement the way you want.  Consulting with a CERTIFIED FINANCIAL PLANNER ™ professional can help you here.
  10. Get Planning Advice to Map Your Route to Your Goals:  Maybe you’ve winged it and thought your home and 401(k) were your tickets to a secure retirement.  Odds are that your planning is not filling the bill.  Sit down with a CERTIFIED FINANCIAL PLANNER ™ professional to discuss your whole picture and map out the action steps that will help keep you on track for financial success.

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The market’s are jumpy to say the least right now.  As I post this the market has ended four days down in a row after finishing August up 3.5% and up 45% since March. 

Despite signs of ‘green shoots’ and glimmers of positive economic activity, the US stock markets have ended the summer rally with a selloff of over 2% (on the DJIA Index).  Fears of a stock market correction or a “W”-shaped recovery loom large after several months of impressive gains.

Manufacturing activity in the US and Europe are mostly up.  Large money-center banks have been paying back the US Treasury for the money borrowed as part of their bailout.  US auto manufacturers are rehiring.

Yet fears that the mighty economic engine of China may slow coupled with worries about the commercial real estate sector in the US have lead investors to take cover.

What’s an investor to do?  Buy and Hold. Or is buy and hold dead as some commentators say?  What about diversification which really seemed to not protect anyone from the steep dive in all markets and all asset classes?

I personally believe that it’s important to follow the time-tested wisdom of grandma:  Don’t put all your eggs in one basket.

But diversifying doesn’t mean “set it and forget it” either which is typical among investors.

To all things there is a season.  And farmers planting crops and fisherman at sea all know that there are cycles in nature.  (El Nino, anyone?)

So why wouldn’t you expect there to be cycles in markets as well?

Considering that stock and bond markets reflect the collective expectations and emotions of millions of investors, it’s an easy leap to expect markets to be governed by cycles in the cumulative raw emotions as well as considered opinions of its many participants.

Example: Right now small-cap stocks have paid off big time this year.  According to the WSJ, stocks in the S&P Small Cap 600 index have leaped over 66% and midcap stocks are up nearly 62%, far outpacing the S&P 500 large cap index which gained “only” 51%.

What a typical investor will do upon hearing such performance will be to move money into this hot sector of the market. And of course that has been exactly what investors have done as more than $7.5 Billion of all fund flows have been to small-cap mutual funds versus outflows of $18.5 Billion from large-cap funds. What’s that saying about “when fool’s rush in?” 

This being said, there are ways to combine investment approaches.

Instead of “buy and hold” it’s time to consider “sit on it and rotate.” 

Ideally, we all want to a perfect investment that always goes up and never goes down.  But a look at one of those “periodic table” of investment returns shows, rarely does the same sector that was a top performer one year do a repeat the following year.

There is a way to get off the wild roller coaster ride between “gloom and doom” and “irrational exuberance.”

This is what I refer to as a “skill-weighted” portfolio.  Essentially, this approach combines various investments in different assets with different investment approaches to help reduce the roller coaster ride.

Even a nesting hen that is sitting on its eggs will rotate positions every once in a while.  And through this approach, too, an investor will maintain a watchful eye on his portfolio being positioned for opportunities by rotating between and among investments, sectors and trends.

Think of a house: a foundation, a frame and then all the visually appealing touches.

In this approach, an investor will have a core foundation comprised of index type investments (mutual funds or Exchange Traded Funds) with a frame consisting of actively managed mutual funds and topped off with a trend-following program for stocks and/or other Exchange Traded Funds to accent the portfolio.  The combination of all these elements will provide balance which helps reduce overall volatility while still positioning for opportunities.

Consider this:  If an investor owns and holds onto an index, he’ll get 100% of the upside … and 100% of the downside.  If an investor owns all actively managed mutual funds, more than 80% do not beat their benchmark.  And those who “market time” need to be right two times:  when they sell and then when they buy.

Not all approaches work all the time but by combining them (rotating between them) an investor may have a better opportunity to preserve, protect and ultimately profit.

What should matter most to any investor is not beating an individual benchmark but getting where they want to go with as few bumps as possible.

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While the market for open-end mutual funds is huge, the market for ETFs is large and poised for growth.  As of 2006 there was approximately $600 billion invested and Morgan Stanley predicts that more than$2 trillion will be invested through ETFs by 2011.

Why are these investment vehicles becoming so popular? How can an individual investor use these to implement a cost-efficient diversified investment portfolio?

 

Exchange Traded Funds (ETFs) were first introduced to institutional investors in 1993.  Since then they have become increasingly acceptable to advisors and investors alike because of their ability to allow greater control over the portfolio construction and diversification process at a lower cost. You should consider making them a core building block to the foundation of your personal investment portfolio.

1. Better Diversification: Most individuals do not have the time or skill to follow every stock or asset class.  Inevitably, this means that an individual will gravitate to the area he or she is most comfortable in which may result in investing in a limited number of stocks or bonds in the same business or industry sector.  Think of the telecom engineer working at Lucent who bought stocks like AT&T, Global Crossing or Worldcom. Using an ETF to buy a core position in the market as a whole or in a specific sector provides instant diversification which reduces portfolio risk.

2. Improved Performance: Research and experience has shown that most actively managed mutual funds typically underperform their benchmark index.  With fewer tools, limited access to institutional research and lack of a disciplined buy/sell strategy, most individual investors fare even worse.  Without having to worry about picking individual winners or losers in a sector, an investor can invest in a basket of broad-based ETFs for core holdings and may be able to improve the overall performance of a portfolio.  For example, the Consumer Staples Select Sector SPDR was down 15% through October 23, 2008 while the S&P 500 was down more than 38%.

3. More Transparency: More than 60% of Americans invest through mutual funds.  Yet most investors don’t really know what they own. Except for a quarterly report showing the holdings as of the close of business on the last day of the quarter, mutual fund investors do not really know what is in their portfolio.  An ETF is completely transparent. An investor knows exactly what it is comprised of throughout the 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 before.

4. No Style Drift: While mutual funds claim to have a certain tilt such as Large Cap or Small Cap stocks or Growth versus Value, it is common for a portfolio manager to drift away from the core strategy noted in a prospectus in an effort to boost returns.  An active fund manager may add other stocks or bonds that may add to return or lower risk but are not in the sector, market cap or style of the core portfolio.  Inevitably, this may result in an investor holding multiple mutual funds with overlap exposure to a specific company or sector.    

5. Easier Rebalancing: The financial media frequently extols the virtues of rebalancing a portfolio.   Yet, this is sometimes easier said than done. Because most mutual funds contain 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 difficult to get an accurate breakdown of the mix to properly rebalance to the targeted asset allocation.   Since each ETF typically represents an index of a specific asset class, industry sector or market capitalization, it is much easier to implement an asset allocation strategy.  Let’s say you wanted a 50/50 portfolio between cash and the total US stock market index.  If the value of the S&P 500 (represented by the SPDR S&P 500 ETF ‘SPY’) fell by 10%, you could move 10% from cash to get back to the target allocation.

6. More Tax Efficient: Unlike a mutual fund which has embedded capital gains created by previous trading activity, an ETF has no such gains forcing an investor to recognize income.  When an ETF is purchased, it establishes the cost basis for the investment on that particular trade for the investor.  And given the fact that most ETFs follow a low-turnover, buy-and-hold approach, many ETFs will be highly tax efficient with individual shareholders realizing a gain or loss only when they actually sell their own ETFs.

7. Lower Transaction Costs: Operating an ETF is much cheaper than a mutual fund.  In a mutual fund, there are shareholder service expenses which are not needed for an ETF.  In addition, ETFs eliminate the need for research and portfolio management because most ETFs follow a passive index approach.  The ETF mirrors the benchmark index and there is no need for the added expense of portfolio analysts.  This is why the average ETF has internal expenses ranging from 0.18% to 0.58% while the average actively managed mutual fund incurs about 1.5% in annual expenses plus trading costs. 

To compare the total cost of owning an ETF with any mutual fund, the Financial Industry Regulatory Authority (FINRA) makes available a Fund & 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 at:  http://apps.finra.org/fundanalyzer/1/fa.aspx .

8. Trading Flexibility 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 like “stop losses” and “shorting,” options not available by “long-only” mutual funds.

Another advantage is the ability to use “inverse ETFs” which may provide some protection against a drop in value of the market or sector.  (An inverse ETF responds opposite the return of the underlying benchmark.  So if one wants to minimize the impact of a decline in the S&P 500 index, for example, then one can invest a portion of the portfolio in an “inverse” which will go up when the index value goes down.)

Or an investor can tilt their portfolio to “overweight” a particular industry or sector by buying more of an ETF index for that area.  By buying an index, an investor can be positioned to take advantage of the expected changes in this industry or area without the inherent risks involved with an individual stock.

Some investors become wedded to their individual stocks or mutual funds and do not want to sell and incur a loss and miss out on the opportunity for an expected rebound. Another tax-efficient option for an investor to consider is to sell the security that is at a loss while buying the ETF representing the industry or sector of the sold security.  This way the investor can book the loss, take the tax deduction for it and still be positioned in the area but with a more broadly diversified index.

Investors, academics and financial advisors sometimes question the strategy of “buy and hold.”  Some investors seek a more active management tactical approach which can be done with ETFs.  Even though ETFs represent passively-created indexes, an investor can actively trade them.  There are a variety of trading strategies available to “manage the trends.”  When an index moves above or below its 50-day moving average or 200-day moving average, this may be a signal to trade in or out of the ETF.  To minimize the trading costs that would be incurred by trading an ETF, an investor can use an ETF wrap program that covers all trading costs.  Typically, such arrangements are still less costly than buying or selling multiple individual stocks in a separately managed account or using an actively managed mutual fund.

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