Friday, February 24, 2012

Why ETFs Beat Stocks and Mutual Funds

Exchange Traded Funds have exploded in popularity over the last decade, and with good reason. They combine the best features of stocks and mutual funds while leaving out many of the risks.

Individual Stocks are problematic because:
  • They subject investors to company-specific risks.

  • It's difficult and expensive to obtain appropriate diversification by accumulating a portfolio of individual stocks.

  • It's time consuming to sift through and research the thousands of stock investments available.

  • It's difficult to keep up with changes which may impact value such as a company's management, structure product and marketing strategy.

Mutual funds are problematic because:
  • Mutual funds are often expensive and tax inefficient (particularly actively managed funds). Investors can be hit with unexpected capital gains taxes even when share prices drop in a given year.

  • They rarely beat the performance of the index or benchmark they claim to track over any significant length of time.

  • The fund can be adversely affected by shareholders' actions including too many orders or too many redemption requests which can force managers to buy and sell at inopportune times.

  • Funds must hold a certain amount of cash which changes asset allocation and can negatively impact returns (known as "cash drag"), particularly in bull markets.

  • Mutual funds only allow trading after the market is closed, which drastically limits liquidity and the risk management strategies that are available.

  • Portfolio managers commonly deviate from a fund's stated investment objective (known as "portfolio drift"), which means investors cannot be 100% confident about their asset allocation.

  • Changes in management, benchmark tracking, and investments held within the funds are difficult to track and evaluate.

Exchange traded funds, on the other hand, allow investors to easily combine the benefits of diversification, asset allocation optimization, and active portfolio management (including trading on margin, short selling, issuing limit or stop ordereds, writing calls, etc) in one single comprehensive and strategy and often even within one single account. ETFs are convenient, transparent, tax efficient and offer no restrictions on trading like many mutual and index funds do.

The biggest advantage, possibly, is that ETFs are often by far the cheapest investment alternative. I was surprised to learn that the average annual expense ratio for an ETF is less than half of that of a comparable index fund - which in turn is generally about half of that of a comparable actively managed mutual fund. The data I have on this is several years old though, so the spread in prices may have narrowed. However it's still true that ETFs affer the lowest expense ratios since the management and administrative fees are so minimal.
One possible downside to ETFs is that if you plan to make small regular investments to your portfolio then the brokerage commisssion or trading fee may not be worthwhile; an index fund which does not charge you to buy shares may be more appropriate.

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