Exchange-traded funds (ETFs) were first introduced to institutional investors in 1993. Since then, they have become increasingly acceptable to both consultants and investors because of their ability to provide greater control over portfolio construction and the diversification process at a lower cost. You need to think about making them the main building block for the foundation of your personal investment portfolio.
1. Best diversification: Most people do not have the time or skills to keep track of each class of stock or asset. Inevitably this means that a person will reach for the area in which he is most comfortable, which can lead to investing in a limited number of stocks or bonds in the same business or industry sector. Think of a telecommunications engineer working at Lucent who bought stocks such as AT&T, Global Crossing or Worldcom. Using an ETF to buy a major position in the market as a whole or in a particular sector provides instant diversification, which reduces portfolio risk.
2. Improved performance: Research and experience have shown that the most actively managed mutual funds do not usually meet their benchmark. With fewer tools, limited access to institutional research, and a lack of a disciplined buying / selling strategy most individual investors go even worse. Without worrying about selecting individual winners or losers in the sector, an investor can invest in a basket of broad ETFs for major holdings and may be able to improve overall portfolio performance. For example, the Consumer Staples Select Sector SPDR was down 15% by October 23, 2008, and the S&P 500 was down more than 38%.
3. More transparency: More than 60% of Americans invest through mutual funds. But most investors don’t really know what they own. With the exception of a quarterly report showing holdings as of closing on the last day of the quarter, mutual fund investors don’t really know what’s in their portfolio. The ETF is completely transparent. The investor knows exactly what it consists of throughout the trading day. And ETF prices are available throughout the day compared to a mutual fund that trades at the closing price of the previous business day.
4. No style drift: Although mutual funds claim to have a certain slope, such as stocks with large capitalization or small capitalization or growth over price, the portfolio manager usually deviates from the main strategy outlined in the prospectus, seeking to increase returns. An active fund manager may add other stocks or bonds that may increase yields or reduce risk but are not part of the sector, market capitalization, or core portfolio style. Inevitably, this can lead to the investor holding multiple mutual funds with overlapping exposure to a particular company or sector.
5. Easier rebalancing: Financial media often praise the benefits of portfolio rebalancing. However, this is sometimes easier said than done. Because most mutual funds contain a combination of cash and securities and may include a mixture of large capitalization, small capitalization, or even value and growth stocks, it is difficult to obtain an accurate breakdown of the mixture to properly balance the target asset allocation. Because each ETF is typically an index of a particular asset class, industry sector, or market capitalization, it is much easier to implement an asset allocation strategy. Let’s say you want a 50/50 portfolio between the cash and the overall US stock market index. If the price of the S&P 500 (represented by the SPDR S&P 500 ETF ‘SPY’) fell by 10%, you could transfer 10% of the cash to return to the target distribution.
6. More efficient tax: Unlike a mutual fund, which has a built-in capital gain created as a result of previous trading activities, an ETF does not have such returns that force an investor to recognize income. When an ETF is acquired, it sets the cost basis for investing in that particular transaction for the investor. And given the fact that most ETFs follow a low-turnover, buy-and-hold approach, many ETFs will be highly effective in taxation if individual shareholders understand profit or loss. only if they are actually selling their own ETFs.
7. Lower transaction costs: Operating an ETF is much cheaper than a mutual fund. Mutual funds have shareholder service costs that are not required for ETFs. In addition, ETFs eliminate the need for research and portfolio management because most ETFs follow a passive index approach. The ETF displays a benchmark, and there is no need for additional costs for portfolio analysts. This is why the average ETF has internal costs ranging from 0.18% to 0.58%, while the average actively managed mutual fund bears about 1.5% of annual costs plus trading costs.
To compare the total cost of owning an ETF with any mutual fund, the Financial Industry Regulatory Authority (FINRA) makes the Fund & ETF Analyzer tool available on its website. The calculator automatically provides commission and expense data for all fund classes and ETFs. The calculator can be found at: http://apps.finra.org/fundanalyzer/1/fa.aspx.
8. Flexibility of trade and implementation of complex investment strategies: ETFs trade like other stocks and bonds. Thus, it means that the investor has the opportunity to use them to use a number of risk management and trading strategies, including hedging techniques such as “stop loss” and “shorting”, options not available “only long” mutual funds.
Another advantage is the ability to use “reverse ETFs” that can provide some protection against falling market or sector value. (The reverse ETF responds against the return of the baseline. So if you want to minimize the impact of a decline in the S&P 500, for example, you can invest part of the portfolio in the “reverse”, which will go up when the index falls.)
Or an investor can tilt their portfolio to “overweight” a particular industry or sector by buying more ETF index for that area. By purchasing an index, an investor can get the opportunity to take advantage of expected changes in that industry or area without the inherent risks associated with a particular stock.
Some investors marry their individual stocks or mutual funds and are reluctant to sell and incur losses and miss the possibility of an expected rebound. Another effective option for an investor to consider is to sell a security that is lost when buying an ETF that represents the industry or sector of the security being sold. This way, the investor can book losses, get a tax deduction and still rank in the region, but with a broader index.
Investors, scientists and financial advisers sometimes question the buy-and-hold strategy. Some investors are looking for a more proactive tactical approach to management that can be done with ETFs. Although ETFs are passively created indices, an investor can actively trade them. There are many trading strategies available for “trend management”. If the index moves above or below its 50-day moving average or 200-day moving average, it could be a signal to trade or exit the ETF. To minimize the trading costs that will be incurred when trading an ETF, an investor can use an ETF wrapping program that covers all trading costs. Typically, such arrangements are still less expensive than buying or selling multiple individual shares in a separately managed account or using an actively managed mutual fund.