Tag Archives: passively traded funds

The Debate Continues: Mutual Funds or ETFs?

  By petillo | July 4, 2011 - 7:43 am | 401k, ETFs, index funds, Mutual Fund Investing, personal finance, Profitable Investments, Repercussions: A Retirement Review, Retirement Planning Target 2025
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Mark Twain suggested: “The reason we hold truth in such respect is because we have so little opportunity to get familiar with it.” This will be the selling point for exchange traded funds: you will hear that they are less expensive, that they are better than the mutual funds – many of them indexed, and that you should own them in your 401(k).

They will suggest you overlook the cost of trading them, the fact that they tempt you to trade them more frequently than ou would a mutual fund and in doing so, allow you to follow the herd on any given day, a behavioral no-no for every investor. So what exactly is the attraction that they want us to see? Are mutual funds better or worse than ETFs?

The answer depends on who you are. If the sort of investor who believes that they can make small moves to harness big gains, then you should probably avoid the lure of ETFs. Exchange traded funds are mutual funds that can be traded just like stocks. They tend to have lower fees than their comparable cohort the mutual fund but the commissions that brokers charge for these trades tend to erase the advertised returns you might get.

If you are the sort of investor who buys to hold, then the surprising choice would be ETFs. Yet you will need to harness the inner trader in you that wants to succumb to the temptation to trade. This sounds easy. But in truth, is no easy feat.

So let’s run some numbers comparing a total stock market ETF sold by Vanguard and a total stock market index sold by the same company. The ETF (trade as VTI) carries and expense of 0.07%. The mutual fund version of the same thing (bought as VTSMX) levies a 0.18% fee on investors. The former has no minimum investment,; the later wants $3,000 to begin. So we’ll start there and propose a hopeful return over 10 years of 4%.

In the first calculated example, the investor made no additional contributions to the investment. Vanguard does suggest that they charge no brokerage fees but they do charge a $20 annual fee for the account. This might be much higher when accessing these funds through your 401(k) and there may be additional brokerage fees. So we’ll assume a $10.00 brokerage fee – as I said, yours might be lower and in most cases, the brokerage charge is on both ends of the transaction.

Based on the above numbers, the ETF, once purchased and held begins to creep past, in terms of raw returns by the third year. By the 10th year, you will have saved about $19.41 in fees giving you a net gain for your ETF of $32.82. But begin adding to the security on a regular basis (say $200 a month) and the differences are much more notable. To add to the ETF in equal proportions over the same 10 year period would cost you $1021 in commission costs and with this money not working for you, the sacrifice in what each would be worth at the end of the 10-year investment period used in our example in addition to the trading cost would leave you with over $1200 less in the ETF account.

Inside a 401(k), where regular contributions rule the way you invest, ETFs can give the average investor less of an opportunity than proponents suggest they will. In a taxable account, bought without commissions such as Vanguard offers and purchased in large lump sums, ETFs slightly trump their mutual fund siblings.

Will you take the time to learn the truth about yourself before making the decision on which investment is better? You are the debate.

ETFs: You will be tempted but should you bite?

  By petillo | June 15, 2011 - 7:20 am | 401k, ETFs, financial planning, index funds, Mutual Fund Investing, personal finance, Profitable Investments, Repercussions: A Retirement Review, Retirement Planning Target 2025, taxes
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I know two things about exchange traded funds (ETFs). There is a high degree of likelihood that your 401(k) will soon have these investments available to you and that some of the basic selling points of why they might be a good choice will be too tempting to pass up. But you should consider the consequences of biting that ETF apple, not just from the consideration of whether the investment is worth the effort, but also from whether you are the investor you think you might be.

So let’s first ask whether you understand what ETFs are. At first glance, they seem to be a good choice. They, at least on the surface offer exactly what index funds do and at times, a great deal more. They claim to be less expensive and more tax efficient that actively managed mutual funds and they are. Actively managed mutual funds, even as they have reduced their overall fees in order to placate those who worry that cost is an issue, still charge more than ETFs.

Actively managed mutual funds still dominate the 401(k) world and with good reason. Investors seem to understand, even after several years of concerted efforts by the investment community, that some risk is worth paying for. This is not always the case. The deduction of those fees against any returns you may have had illustrate why these funds are often criticized. Comparing them to an index fund, while often not necessarily fair, further shows that had you paid less in fees using an passively managed index fund you probably would have been a little bit closer to what you think of as profitable.

Passively managed funds such as index funds have passionate advocates. They believe that investing in the low-cost (because they rarely trade and do so only rebalance when the index changes) and in the case of the S&P 500 index, reinvest dividends (over 350 companies in the 500 index do) you have achieved the tax advantage, the fee advantage and because of that, a more profitable retirement dollar.

Both of the descriptions of the two most commonly used types of funds in a retirement account portray the investment possibilities facing most investors. It should be noted that not all 401(k) plans have index funds available to their participants, the option is growing. But also entering the fray is the exchange traded fund.

Now these investments will be tempting. They tout their tax efficiency suggesting that it is even better than an index fund offers. They advertise their transparency and ease of trading (they trade on an exchange just like a stock). And they never fail to tell you that these investment offer the world in a way that has never before been offered to 401(k) investors, a chance to invest in commodities, emerging markets and anything in-between. And because of this ease of maneuvering in and out on a whim, they claim to lower risk as well.

But do they do what they claim they will do? This is debatable. First, they are not index funds. They do not necessarily purchase all of the stocks in an index even as they suggest they might. Instead, many ETFs create their own indexes to follow and seek to invest in places where indexes have yet to trod. Mark P. Cussen, a financial planner for the military wrote recently about a little understood method employed by ETFs to get gains that seem better than the index they are suggesting they mimic. He wrote: “Most of these funds are usually leveraged by a factor of up to three, which can amplify the gains posted by the underlying vehicles and provide huge, quick profits for investors. Of course, leverage works both ways, and those who bet wrong can sustain big losses in a hurry.” Leverage is another word for borrowing.

If there is an asset class, there is an ETF looking to exploit it. if you are hearing a lot about a certain class, such as precious metals, the temptation to join in the fray might be too hard to avoid. ETFs allow you to jump in “with the herd” and sell “with the herd”. neither are necessarily a good idea and if you keep in mind, the low cost and tax efficiency of doing so are mostly wiped away. In order for ETFs to be both of those, you need to buy in large lots, offsetting the cost of the trade (commission) and you need to hold them for over a year. Small traders, which is the vast majority of us do neither – and won’t if you buy them.

I mention “the herd”. This mentality os what will drive you to consider this investment once it makes its debut in your plan. Instead, consider the vanilla index fund and what has become known as the tactical strategy. This employs a portion of your plan to just such whims while keeping the larger portion in the funds that will do the best with the least cost.

A tactical strategy might look something like this for young to middle aged investors: seventy percent of your assets in three to six index funds and thirty percent allocated to ETFs or even actively managed funds. Older investors might do the same but keep in mind that many major economic watchdog groups have warned that ETFs could be the next global financial troublemaker. And if that happens and happens quickly, the losses on that side of your portfolio close to retirement might find you less likely to retire when you want.

You will be tempted. And many of you will bite. But don’t think that this investment can’t bite back. It can and it might and unless you plan for such an occurance, the teethmarks it leaves in your plan might be long-term and scarring.

The Lure of ETF Investing: Why Exchange Traded Funds Misrepresent

  By petillo | April 18, 2011 - 7:59 am | ETFs, financial planning, index funds, Mutual Fund Investing, personal finance, Profitable Investments, Repercussions: A Retirement Review, Retirement Planning Target 2025, taxes
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If you have been a passive investor in index mutual funds, ETFs have caught your attention and quite possibly your sense of wonder. If you are someone who considers yourself an active investor, ETFs have also played to your most basic instincts. Can one investment do both?

In short, yes and no. The idea behind passive investing is the ability to let the market do what it will. The concept of passive suggests that by allowing an index to track a broad market, you can benefit over the long-term. History has proven that index funds have had a great deal of success in doing just that. They take the trader out of the picture and replace it with an investor. Buying an ETF will also allow you to do exactly the same thing, with the same sort of tax efficiency, the same kind of transparency and of course, because it is an index it also does this at an extremely low cost.

But buying an ETF, even as it mimics this passive mutual fund experience, draws on another more base instinct: the ability to gamble. Exchange Traded Funds are purchased just like a stock, on an exchange. And because there is that additional element – the broker in the middle – additional charges are added to the purchase that otherwise do not exist in buying the same investment (or the same type of investment) as a mutual fund.

True, you can alleviate much of those costs by using a low-cost broker. But few traders calculate this cost against the purchase. Instead they see it as a cost of doing business, the price of easy access that is easily dismissed and often overlooked as the calculate success or not.

Since they were first introduced in the 1970′s and formally in 1993 by State Street Corp.’s State Street Global Advisors, over a trillion dollars have been placed in these passive investments. And during that time, the kinds of ETFs available have sliced and diced the markets into ever smaller pieces, indexing more obscure corners of our investment desires. And it is those desires that present the problems.

Don Phillips, president of fund research at Morningstar found the coupling of trading actively and investing passively as the real problem in these investments. Quoted in a recent Wall Street Journal article on the topic of ETFs, he expressed his dismay over their popularity: “One was this trend toward lower costs and passive investments—generally healthier behaviors. On the other hand, what they have tapped into is the human love of gambling—the need for action and trading.”

Acting on those behaviors, ETF issuers have cared little about the investor and this instinct to take risk. While no investment comes without some sort of risk, ETFs continue to mask their exposure by suggesting that these tools are less volatile than stocks. And in truth they are. But they are markedly more risky than the same investment used as fund. And because traders use them to hedge bets and leverage their positions, they actually add volatility to the very markets they use.

This leaves the average individual investor in exactly the same spot as the same investor who buys individual stocks: at the mercy of too many players in the same game, which most advisers would suggest is a recipe for disappointment. When everyone knows what you know and quite possibly knows it if only a few seconds before you do, the edge you think you might have is gone.

So do you buy an ETF or not? No, if you currently have investments in index funds in place in your retirement account. And statistically, you should also have them in your taxable accounts as well. You can slice and dice these types of funds to build a portfolio that invests in all facets of the markets and do so without increasing the risks. In fact, you will actually level off the overall risk by doing so.

Yes, if investing the old-fashioned passive way is simply not exciting enough. Keep in mind each trade comes with a cost. Each purchase that charges a commission takes away from any gains you might have and if an indexed ETF is what it suggests it is, those gains will come slowly. And one thing your research will uncover, no one talks about the losses. The folks who tout the advantages of owning an ETF simply don’t mention this simple truth, as if ETFs never went down in price. They will tell you, instead about ETFs that short the market of play inverse strategies. Add to that: the more obscure the index, the greater the risk as well. As ETFs index ever more complicated areas, including emerging markets, commodities and precious metals, the risks increase in kind.

Keep in mind, that this is neither an endorsement or advice to do one thing or another. Nothing I say will change your mind about these investments. If you have begun to consider them as something you would like to try, keep in mind that you may already own a number of the underlying stocks in other investments.