Are You a Dinosaur for Not Investing in ETFs?

The following guest post is from Neal Frankle of Wealth Pilgrim. Wealth Pilgrim is on my short list of daily reads. After reading the post, head over to Neal’s site and sign up to receive his posts.

ETF’s (Exchange Traded Funds) are pretty darn popular these days.  The total dollars invested in these buggers grew 45% last year to $242 billion.

You probably read about ETF’s where ever you go and you might feel like a relic for not owning any.  I’d like to explain what they are, how they can be used and why you might be just fine not worrying about them at all.

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First, what are ETF’s?

Think of these as mutual funds.  They both have a lot in common.  Like funds, an ETF owns a basket of stocks. When you buy into an ETF you own a small portion of each stock – just like you do when you buy a fund.

So how are they different?

Well…the ETF usually holds on to the shares they buy.  There is very little buying and selling.  They simply buy the stocks that are held in an index and they only buy or sell when the people who run the index replace one company with another. A mutual fund on the other hand buys and sells shares much more often.  This is the core issue that separates ETF’s and funds.

Because ETF’s have little trading activity, they offer much lower costs and fewer tax problems.

You see, if a fund trades shares, they need someone to do the trading and other people to make the decisions.  These people are usually very highly paid and that’s one of the reasons why funds have higher expenses.

Are the high costs of trading and fancy managers worth it?  Do funds have a higher return than ETF’s?

Usually not.

Depending on the year, 70% to 80% of the actively managed funds fail to outperform the indexes – and ETF’s are just index funds.

So, should a reasonable person conclude that it’s silly to buy mutual funds.

Well….yes and no.

“”Yes – stick with ETF’s “ if you are a buy and hold investor.  ETF’s are less expensive and that’s the reason why they outperform 70% to 80% of the actively managed mutual funds.  That being the case, if you buy and hold your funds, get some broadly based ETF’s and hold on to them.

But that’s not the end of the conversation.

Let’s say you don’t believe in “buy and hold”.  Let’s say you use a strategy that reviews market strength and you update your portfolio often.

In that case, you shouldn’t restrict your investments to only ETF’s.

You should buy the fund (or ETF) that is performing best according to the strategy you use and the criteria you select.

That’s right.  Not everyone is a “buy and hold” investor and not everyone should be.

Some people try to reduce risk by using approaches like these and it’s not something you should dismiss out of hand.

Some investors try to buy funds in stronger areas of the market, stay away from areas that are weak, and possibly get out of the market all together when they see storm clouds ahead.

Do these people make more money than buy and hold investors?  Sometimes they do.  Sometimes they don’t.   Keep in mind that people who use strategies like these don’t always do so because they want to make more money.  They often use these types of approaches because they don’t want to suffer catastrophic losses.

Of course, no matter what approach you use or what investments you use, ETF’s or actively managed funds, you can still lose money.  No matter how you approach investing, there will be periods where you won’t do well. That sucks but it goes with the territory.

The bottom line is that, in reality, the debate between ETF’s and actively managed funds is all marketing and doesn’t mean squat to you.  Well…wait…I take it back….it might mean that you lose focus on the really important issues when it comes to investing and as a result you lose your shirt. So besides ETF’s, are there no other investment strategies that work?

So, should a reasonable person conclude that it’s silly to buy mutual funds?

Well….yes and no.

So what are the really important issues?

Your financial goals.  Your financial timeframe.  Your investment approach.  Your clarity on the first two and your willingness to stick to the third concept no matter what.

Do you only invest in ETF’s?  If so, why?

Photo by kevindooley

Comments

  1. I’ve probably been out of the loop for quite a while now because my husband thinks I get too anxious or depressed whenever finances are being talked about. But I just might ask him about this to see if he thinks this is a great investment. Thanks for sharing. :)

  2. Not all ETFs are passive index funds. So please don’t come away that misconception. Mutual fund companies are jumping on the ETF band wagon to introduce actively managed ETFs that will turn over their portfolio and generate capital gains and losses. Most ETFs have low expense ratios because they don’t have to maintain the typical mutual fund back office operation to process cash in and out. But expect expense ratios to increase as more mutual fund companies get in the game. ETFs can be traded all day long encouraging speculation. They also have bid/ask spreads, discounts or premiums to Net Asset Value, and broker fees. For the small investor it is still probably best to stick with a traditional index fund through someone like Vanguard. Only very long term holders of passive index ETFs will see the benefits of the lower fee structure.

  3. I agree w/all your comments Biz…….

    I think it’s really important to focus on your goal — which usually includes making money.

    That being said, who cares what the expenses are? Let’s look at the results. And often, the ETF results aren’t there.

  4. Neal, if you’re a buy and hold investor, what about index funds rather than the ETF? I know your post was on the comparison between ETFs and actively managed funds, but here are my thoughts.

    Correct me if I’m wrong, but while index funds have slightly higher expense ratios, ETFs charge a commission for every trade, just as in the case for a stock. So if you’re a buy and hold kind of person, wouldn’t the ongoing commission charges from regular ETF buying eat away at your returns, as opposed to buying through an index fund?

    I personally don’t invest in ETFs for this very reason, and just stick to index funds.

    • I actually am not a buy and hold investor so I don’t restrict myself to any particular group. I also dislike the commissions and even the ETF’s with no commissions have higher management fees.

  5. Loved the last paragraph Neal.

    I think it’s more of a debate between ETF’s and mutual funds based off the same index. Both have their advantages, would be interesting to know what you think Neal.

    • RJ,

      I look at short-term performance – 1 year and less. As a result, I rarely find an ETF that makes the grade. If I can’t find a fund that beats the index (rarely) I’ll buy the index. Usually an index fund but possibly the ETF.

  6. If you manage your own investments through a brokerage account, ETFs are clearly the easiest way to diversify your portfolio. I started trading stocks and now almost exclusively trade ETFs. In addition to benefiting diversification, ETFs, like stocks, are very easy to trade and portable. If I find a better deal at another discount broker, I can just transfer my entire portfolio for a small fee.

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