by Joe Beckford
Achieving your long-term financial goals takes discipline and focus. It takes identifying a strategy and sticking to it. It takes ignoring the distractions and market buzz swirling around you and keeping your eye on the horizon.
Once you partner with your advisor to identify your appetite for risk and come up with a plan, what are some investment vehicles you can use to actually execute your plan?
One good option is investing in broad indexes using ETFs.
What Are ETFs?
ETF stands for Exchange Traded Fund. This type of investment seeks to match the returns of an index by investing in the securities within that index. For example, an S&P 500 ETF seeks to match the returns of the S&P 500 by owning a representative piece of all the stocks that comprise that index.
Although they are a relatively newer type of financial product, ETFs have been around since the early 1990s and have become commonplace in many well-diversified portfolios in recent years.
ETFs have some similarities with mutual funds. They are both baskets of individual securities (stocks and bonds), and they both allow you to invest in broadly diversified portfolios without purchasing a lot of individual stocks and bonds.
But ETFs also have some important differences:
- ETFs are passively managed. This means that the managers of an ETF build their portfolios to mirror their index, and there is very little trading or turnover unless there is a change to the index. While there are index mutual funds out there, most funds are actively managed and may involve a lot of internal trading.
- They are very tax-efficient. The lower turnover of ETFs means they generate very little capital gain distributions compared to active or index mutual funds, so they can be a great choice for portfolios where taxes are a concern.
- Passive management also means lower fees. ETF managers are only seeking to represent an index, and are not trying to employ convoluted strategies that involve complex analysis or frequent trading. ETFs with expense ratios below 0.2% are not uncommon, whereas actively-managed mutual funds may have fees close to or above 1.0%.
- ETFs are traded on an exchange throughout the day, while mutual funds are traded once at the end of the day.
Are ETFs a Good Idea?
There have been several studies that indicate that active stock picking often fails to match or beat overall market returns. There have also been several studies that indicate that your broad asset allocation (the mixture between stocks and bonds as well as different asset classes) is the main determining factor of your portfolio’s returns.
What this means for you is that the broader diversification of your portfolio is much more important to achieving your financial goals than specific security selection.
A well-diversified portfolio of ETFs allows you to have broad exposure to a variety of asset classes without having to worry about selecting specific stocks or bonds or paying a mutual fund manager high fees to do it for you.
Passive management and lower turnover mean that you will save on internal management fees and will have less of a tax burden. This adds directly to your bottom line returns and makes ETFs a very attractive option for a diversified portfolio.
What Are Some Things to Watch Out For?
One of the biggest draws of ETFs is that they offer easy access to broad diversification. But to have this benefit, the ETFs you own should not be too specific and should not have too much overlap.
There are ETFs out there for every index and asset class you can think of, from the Vanguard Total Stock Market ETF (VTI) to the iPath Livestock Sub-Index ETF (COW). ETFs that are too narrow won’t offer you the same diversification benefits as broad-based ETFs and have the potential to throw off your asset allocation if not combined properly with complementary investments. Broad index ETFs offer you greater exposure to the wider market and are simpler to properly diversify.
With all the ETFs available out there, there can be several that track the exact same index. There’s no reason to own both the SPDR S&P 500 ETF (SPY) and the Vanguard S&P 500 ETF(VOO), as they both invest in the S&P 500 index.
Your ETF portfolio should have a collection of ETFs that both give you broad exposure to the overall market and prevent you from over-concentrating in any one specific area. A well-diversified model that includes ETFs will achieve these goals.
ETFs are very attractive investments because low fees and overall tax efficiency can add to your return over time, and the right combination of ETFs can give you broad diversification across asset classes. For the long-term investor who is more interested in achieving their financial goals than following the daily ups and downs of the market, ETFs can be suitable for inclusion in a well-diversified portfolio of high-quality, low-expense investments.
 “Determinants of Portfolio Performance II: An Update,” Gary P. Brinson, Brian D. Singer and Gilbert L. Beebower, Financial Analysts Journal, 1991.