First, let’s get my bias out in the open because I think it’s important for you to understand where I am coming from relative to this topic. I am a big fan of ETFs. The majority of my personal portfolio is held in ETFs, and that percentage is ever-increasing after I learned more about them and the advantages they offer. Now that we’ve got that out of the way, we can begin.
ETFs, or Exchange Traded Funds, are a collection of various investments sold as a single investment. For example, let’s say you want to invest in the energy sector. You could either research the top 50 energy companies, determine their relative size (i.e., ABC Energy is twice as big as Energy Inc), and then purchase a proportional amount of each of those 50 companies’ stock. Or, you could find an Energy Sector ETF and simply buy that one investment. Or, if you bought an S&P 500 ETF, you could buy a single “share” of the S&P 500, which is a collection of 500 different companies across various sectors and business models.
The benefits to ETFs are many, but I’ll highlight my top few below:
ETFs allow you to diversify your investment dollars across the entire market or across an entire sector. This can be incredibly valuable, as most of us don’t have the time and resources to be able to do a full company analysis on each individual investment we plan to make.
Take the example from above. If you wanted to invest in the energy sector as a whole because you believe there will be good returns from this sector overall, you could buy an Energy ETF. This built in diversification prevents you from buying a single energy company and putting all your eggs in one basket.
The same can be said for diversifying even more broadly. Rather than diversifying across a single sector or industry, ETFs allow the individual investor to “buy the market” by purchasing holdings in things like an S&P 500 ETF or an ETF that focuses on large cap stocks. You can also invest in domestic-focused ETFs or ETFs focused on a particular international region (for example, a European-focused ETF).
The reason this built-in diversification is important is that it creates investing discipline. Many investors fall victim to the believe that they can pick the winners in the market and only ever invest in companies that will outperform their sectors or the market in general. The reality is, however, that they cannot.
Warren Buffet, in 2008, made a bet that professional hedge fund managers couldn’t out-perform an S&P 500 ETF. He was right. The professional stock pickers, armed with all their knowledge, analysis, and experience failed to outperform a well-diversified, low-cost S&P 500 ETF.
Not only did he make this bet publicly to prove a point and demonstrate the value in buying the entire market, but he gives the same advice to his wife. When Warren Buffett dies, he has advised his wife to “put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.” Here he is practicing what he preaches, even if after his passing.
Lower Cost of Entry
If you are sold on the value of diversification, you may argue that you can handle your own diversification through purchasing individual stocks that make up these sectors or markets. This is true. However, the cost of entry to do so via individual stocks is extremely high as compared to buying a single share of an ETF.
Let’s work through a simplified example:
If you wanted to invest in an ETF that tracks Facebook, Apple, Amazon, Netflix, and Google (collectively referred to as FAANG) while maintaining their relative weighting, you would find their relative weightings to be:
Knowing that you would have to buy whole shares, to try to get those weightings close to accurate, you would need to buy 10 shares of Facebook, 18 of Apple, 2 of Amazon, 1 of Netflix, and 3 of Google. The total cost of these investments would be approximately $14,000.
Alternatively, if you could buy a FAANG ETF, the price of that ETF may be $300 per share. That $300 would be distributed across the individual investments with accurate weighting – meaning that your $300 would be invested in $47 of Facebook, $83 of Apple, $80 of Amazon, $14 of Facebook, and $75 of Google.
Every investor is different, but a $300 ETF has a lower cost of entry than building the basket of holdings yourself with a price tag of $14,000. And if you had the $14,000 to invest, you could simply buy 47 shares of the ETF instead.
Generally Lower Fees than Mutual Funds
Yes, it is true, ETFs do have fees. There is a company doing the back-end work in the FAANG example above on your behalf, and for that service, they need to be compensated. For a standard S&P 500 ETF, we’ll use VOO – Vanguard’s S&P 500 ETF. VOO currently has an expense ratio of 0.04%. That means that for every $10,000 you have of VOO, Vanguard will charge you $4 per year.
ETF fees can range based on the provider of the ETF and the sector you’re trying to invest in. These fees can range as low as 0 (Fidelity recently announced 0% fee ETFs), but the average ETF fee was 0.23% in 2016.
Comparing ETFs to something like Mutual Funds or even Active Funds, the lower fee benefit can be seen. The average fee ratio in 2016 for index mutual funds was 0.73% and 1.45% for actively managed funds.
While these factional percentages may not seem significant, if you look at the difference in ending balance after a 30-year period – even assuming the exact same rate of return – the impact begins to come into focus. For this example, let’s assume a 7% rate of return before fees, and a $5,000 per year contribution to the portfolio. At the end of 30 years, the balances would be this:
Index Mutual Fund: $441,000
Actively Managed Fund: $386,000
That’s $40,000 more vs a Mutual Fund, or nearly $100,000 more vs an Actively Managed Fund!
This doesn’t mean that ETFs are the best investment vehicle for all situations and at all times. There may be cases where you want to buy individual stocks or where mutual funds or active funds may make sense. My wife and I, in addition to our ETFs, do hold individual stocks as well as mutual funds. There isn’t a one-size-fits-all option when it comes to investing. The key is to understand the differences and which situations may lend themselves to different types of investment. Once you have that understanding, you can make the best decision for you and your family.
I have a friend who likes to day trades stocks, and I love to hear the stories about him making a great trade or capitalizing on a nice run. While these things do happen, day traders still experience their fair share of misses, and it takes up a significant amount of their time each day. The honest truth is that most of us don’t have the time to be trading stocks regularly or activating buy and sell orders on the most recent news.
While this lifestyle can be appealing to some, I think most of us simply don’t have the desire or time to do everything that’s required to make it work out. That’s where a lot of the points Eric made above come in to play: ETFs can make a lot of sense for your average investor. Even better, an ETF isn’t only simpler to execute, but in a general sense, ETFs can outperform individual stock picks or mutual funds. Why not make your life easier an invest in an ETF of your choice?
The honest truth is that it is hard to argue with Eric’s rationale above. For the situations he describes, ETFs are a tremendous option. You have a variety of choices, built-in diversification, low fees etc. almost any investor could get started with these and reflect the market, industry or whatever there is an ETF for.
The decision you end up making is ultimately going to boil down to your strategy. In many of Eric’s examples above, the ETFs he discussed followed the performance of the S&P 500 or a particular sector. But what if you believed the S&P 500 was going to decline in value? Is there an ETF that will increase in value if the stock market drops?
These are great questions, and they are not without rationale. Back in the second half of the 2000’s, John Paulson made a series of bets against the U.S. housing market. This was during a time of rapid growth and when everyone, including the credit bureaus, all believed the housing market was unstoppable. John Paulson ended up being right, the housing market crashed, and he made billions.
The question is, if you would like to bet against the value of the S&P 500, can you do that with ETFs? The answer is yes. Called an Inverse ETF (or “Short” or “Bear” ETF), this instrument allows you to bet against the underlying value of the assets. Why might someone want to do this? Maybe they simply want to place a bet that the market will decline. Maybe they want to hedge themselves against another bet they made. At the end of the day, the important thing is that this allows even further flexibility when investing in ETFs.
At the end of the day, every investor has to choose the strategy that best meets their goals. There are a lot of ways to allocate your money, and ETFs are just another great tool that really open up a lot of great possibilities for all investors, professional and novice alike.