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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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