ETFs – A Light Bulb Moment for Investors

How many stock brokers does it take to change a light bulb? There’s nothing like a good light bulb joke to point out the inefficiencies, redundancies, and over thinking that takes place in most professions. The question we’ve been asking ourselves as investment professionals more and more is “How many portfolio managers, research analysts, and traders, does it take to underperform the market?” Unfortunately, for investors holding actively managed mutual funds and separate accounts in their portfolio this is no joke.

Each year the S&P Dow Jones Indices analyzes the returns of fund managers versus the performance of their respective benchmark. The latest results from year end 2014 highlight what has been the trend since they began publishing the report 11 years ago; that the overwhelming majority of funds underperform.

Profolio Investments prefers to use an indexing approach to better help our clients reach their short and long-term objectives. In our view, it is far more important to manage risk in a portfolio than to pick stocks. In this regard, we are frequently asked about the benefits of Exchange Traded Funds (ETFs).

Diversification

Like mutual funds, an ETF is a diversified portfolio of securities. Underlying securities within an ETF can include stocks, bonds, foreign currencies, commodities, or exposure to other assets such as real estate.  The majority of ETFs are designed to track the performance of a market or sector index. Examples of such an index would be the S&P 500, Dow Jones, or Russell 1000. As the index performs, so should the ETF. A well-designed ETF will have nearly identical returns as it’s underlying index, measured by what’s known as it’s tracking error. The fund holds only the investments that are within the index. There is no active buying or selling of securities which is why they are often referred to as being “passively managed”. This is in contrast to a mutual fund that is actively managed by a team of individuals made up of portfolio managers, research analysts, and traders.

Lower Fees

Because Exchange Traded Funds are by design much simpler with less overhead, they come with a significantly lower price tag. The average annual expense for an equity based ETF comes in around 45 basis points (0.45%) while equity based mutual funds on average charge a much higher 1.42%. Even further, investors can find many major broad based index ETFs at a fee of less than 15 basis points. In all of Profolio Investments’ ETF based model portfolios, we’ve been able to target an ETF expense of under 0.25%. Savings of over 1% per year in fees can have an astounding impact when the long term compounding effect of an investment portfolio is considered.

Highly Liquid

Another defining trait of ETFs is that they are tradable through market exchanges (like the New York Stock Exchange), as their name indicates. This means they can be bought or sold throughout the day in the same way you would buy or sell a share of stock. Investors thus have the benefit of being able to place multiple order types including market, limit, and stop loss orders. With many ETFs, trading call and put options is also a possibility. One consideration here is that due to it’s dependency on active markets, ETFs can trade at prices that differ from what is know as its Net Asset Value (NAV), or the combined value of it’s underlying investments. For most highly traded broad based index ETFs this premium or discount to NAV is negligible. ETFs are also subject to brokerage commissions when traded through most brokerages. However, clients of Profolio Investments are able to trade ETFs within their portfolio commission free.

Tax Efficient

Tax efficiency is another characteristic associated with ETFs. Because there is very little trading in and out of securities, it is rare for an ETF to make capital gain distributions common with most mutual funds. Additionally, when the owner of an ETF sells their shares, they go to a buyer in the open market. Thus underlying securities in the fund do not need to be liquidated like they do when an investor redeems shares of a mutual fund, again avoiding the need for the fund to pay capital gain distributions. As far as dividends go, as long as an underlying holding in an ETF pays a qualified dividend (qualifies for a reduced tax rate), the dividend is distributed to the owner of the ETF as a qualified dividend, assuming applicable holding periods have been met.

Other Considerations

Since the early 90’s, hundreds of Exchange Traded Funds have been created that essentially cover all sectors of the market. Diversified investment portfolios can be easily created using ETFs that cover investment grade and high yield bonds, US stocks, international and emerging market stocks, and alternative investments including commodities, and real estate. They can be purchased in any account form, both taxable and non-taxable (such as an IRA), that facilitates trading in stocks. With all of the advantages of index investment strategies it’s easy to understand why ETFs continue to capture market share from actively managed funds.

However, as the popularity of ETFs has grown, and the number of available funds expands, investors need to understand that not all ETFs are created equal. The market has been introduced to a number of funds that may not be as transparent or straightforward as the more common broad based index funds. Fund types identified with “Leveraged”, “Inverse”, or “Alternative” to name a few should be deeply understood prior to being incorporated into a portfolio. As with any investment it’s imperative to understand the nature of the investment and how it fits in the context of a broader portfolio.

Profolio Investments is a full service investment management and wealth advisory firm. We can help you implement a smart investment strategy suited to your objectives…and in case you were wondering, the answer is 3. One to buy a call option on a new light bulb, one to pretend the broken bulb is okay and to sell it to a client, and one to charge a commission on both trades.

Michael Scheel

Profolio Investments Inc, 121 Newark Avenue Ste 544, Jersey City, NJ, 07302