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.
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?
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