What’s an ETF and why do some folks swear by them?
This is the overdue part two to a piece on some terminology and investment strategy. Part one was titled “The Dow was up today. That’s great, but what exactly does that mean?” and posted 11/1/19.
Investopedia1 defines an ETF as follows: An exchange-traded fund (ETF) is a type of security that involves a collection of securities—such as stocks—that often tracks an underlying index, although they can invest in any number of industry sectors or use various strategies.
Again, most of you are probably saying “English please!” Here goes:
There are two main features of ETFs that I want to highlight.
1 – ETFs can be bought and sold on an exchange throughout the day, unlike mutual funds which are transacted upon at the close of trading once per day. In that way, ETF’s trade/transact more like stocks.
2 – ETFs are often setup to mirror well-known Indexes (see 11/1/19 blog post for definition), although they may track specific sectors or other criteria. There is generally low turnover of the securities held in their portfolio (read: not a lot of buying and selling.) This is similar to an index mutual fund but very different from an actively managed mutual fund (which is the type many people are more familiar with).
Part two is the idea I really want to discuss in more detail. Let’s take an S&P 500 ETF to look at. In theory, if you were to purchase such an ETF, you would then hold a piece of each of the 500 companies that comprise the S&P 500 Index. That is not always the case, some ETFs don’t use all 500, but for this example let’s stick with it.
Owning a piece of 500 companies sounds great, and if you’re looking for diversity, you will have achieved it for sure (maybe even too much diversity, but we’ll get to that later). The downside here is that the ETF is constructed to match the index. So the next logical question is what is the index constructed of? In the case of the S&P 500, the companies included in the index are selected by a committee and the goal of the S&P 500 index is that the companies included are representative of the industries in the economy of the United States. That sounds all well and good, but if you ask yourself the question “does the committee select a stock for inclusion because they believe it is going to make money?”, the answer is essentially no. The criteria for company/stock selection do not include the belief that the share price will increase.
ETFs are often referred to as a “passive investing” strategy for reason described above (although this is not always the case!)
Conversely, on the more traditional actively managed mutual fund side, a Large Cap Growth fund manager might be trying to outperform the S&P 500 index by investing in their favorite 30-60 (or more!) companies within that 500, and maybe a few that aren’t included in the index. This also sounds great, but with that active management comes a higher cost to the investor.
This alone is the reason many investors swear by ETFs over active funds - they generally have lower investment fees. Some may ask “well why would I ever want to pay more for an investment?” and conclude ETFs are the way to go. Period. End of Story.
I contend that cost is a piece of total return, and one of the factors in making the decision of active or passive.
At this point, a Pro’s and Con’s chart probably comes in handy and the following are my opinion only. I’ll explain a bit on each under the table:
Type Index ETF / Mutual Fund Actively Managed Mutual Fund
Cost PRO CON
Diversification Wash Wash
Up Market PRO CON
Down Market CON PRO
Choppy/Flat Market CON PRO
Investment Selection CON PRO
Tax Impact PRO CON
If you’re keeping score, that’s 3 Pros and 3 Cons to each plus a wash. So pretty even by my unscientific method.
My Reasoning:
Cost – Limited or no research required by Index ETFs and mutual funds into security selection translates to lower fund maintenance costs which translate to lower expense passed to investors. Many “thrifty” investors do not get past this point in their decision making. I don't want you to think I don't like "thrifty" investors or that they've got it all wrong - everyone has their own criteria that are most important to them. Heck, even after a full analysis, these thrifty investors may indeed have been better off choosing this strategy anyway, but what I am saying is that to me the active vs. passive decision bears more consideration than solely the mutual fund expenses.
Diversification – I say this is a wash because after you get past about 20 individual securities in a fund, how much more diverse do you really need to be? I’m all for diversification across sectors and asset classes, but many securities in an index fund will be representative of the same industry/sector and not really help your investment be more diverse from a performance standpoint.
Up Market – Index ETFs and mutual funds will generally outperform all but the best performing Actively managed funds in an up market. This has something to do with lower fund expenses for sure but also that it seems harder for Active managers to pick the “best winner” securities when everything is going up.
Down Market – I think active funds do better here. The active fund manager typically has some discretion (within the parameters set forth in the fund prospectus) to raise cash by selling some holdings and positioning a fund more conservatively if they deem it appropriate. On the index side, unless you switch out of an aggressive option to a more conservative one, you will pretty much be along for the ride and follow the market/index downwards. Additionally, many times changing from one ETF to another involves transaction fees which can add up if done frequently.
Choppy/Flat Market – I feel this is where active managers earn their chops. When markets are changing rapidly there can be overvaluation and undervaluation of securities and active managers can take advantage where they see opportunity. Index ETFs and mutual funds simply track their intended index and in this type of market climate there really isn’t a resounding alarm for investors to change from one fund to another as there might be in a down market.
Investment Selection – Active managers perform underlying research on their fund holdings and in theory this should produce a better opportunity for share price growth as compared to mirroring an index.
Tax Impact – ETFs generally change underlying holdings less frequently which results in less capital gains passed on to investors. Someone with a taxable investment and seeking to limit their capital gains may be well advised to at least consider ETFs in their portfolio.
All of the above is comparing a "traditional" S&P 500 ETF to an active mutual fund with similar investment objectives. To add a bit more complexity to the discussion there are newer ETF strategies that are more refined in their construction and could certainly change the Pros vs. Cons outlook above. An example might be an ETF that only holds S&P 500 companies which have demonstrated rising or equal dividend payments for the last 20 consecutive years – zero decreases in dividend payments. That may narrow it down to 35 companies and then that ETF is comprised only of those 35.
Conclusion
What I want you to take out of this is A) a little more knowledge on the subject and B) there are many factors that go into choosing Active vs. Passive investing.
Personally, all else being equal I generally prefer the active strategy in most cases. This is mainly because I believe this strategy would lose less in a market downturn. After all, part of long term total return is limiting losses. Also with active funds you are effectively getting two levels of expertise/management – you can have the advisor to help you select the fund(s) (and change funds when necessary) with either passive or active strategies, but adding the second layer of the fund management team to constantly evaluate the holdings in the funds is in my mind a “Pro”.
There’s always a “but” in the investing world and this situation is no different. So here it is…
Even though I may prefer active in many situations, passive investing has it's place in many portfolios. A few years ago I began including some newer passive strategies in portfolios for clients where it makes sense - particularly in taxable accounts.
So what’s the answer, active or passive?
My bottom line is it’s worth looking into to find out which strategy or strategies are right for you, and I can help with that!
1 – Investopedia is not affiliated with Jones Financial Group or LPL Financial
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Investment value will fluctuate and shares, when redeemed, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares of ETFs are bought and sold at market price, which may be higher or lower than the net asset value (NAV).
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