Why So Many ETFs?


Posted in: Economics, General, Stock Market, Thought of the Week

Many investors have noticed some big changes to the composition of the DIAS portfolios this year, as several stocks have been sold and replaced with Exchange Traded Funds (ETFs).

An ETF is a marketable security that tracks an index or a basket of stocks, bonds, and/or commodities. The fund owns the underlying assets and then divides ownership of those assets into shares. These shares of the ETF are then traded on stock exchanges.

For example, if an ETF were created to track social media stocks, the fund would buy Facebook, Twitter, and other stocks in the sector, and then issue shares to investors that gave them a claim on a portion of the value of the fund. Over time, the value of the ETF shares would rise/fall as the portfolio value changed due to the movement of the stocks within.

An ETF may sound similar to a mutual fund, but they are actually quite different for several reasons. Unlike mutual funds, ETFs:

  • Trade throughout the day and experience price changes like regular stocks.
  • Offer favorable taxation since capital gains from sales inside the ETF are not passed through to shareholders.
  • Charge relatively small fees (typically below 0.005%) and are less actively managed.

The three most important rules in real estate are (1) Location, (2) Location, and (3) Location. When it comes to investment management, the three most important rules are (1) Asset Allocation, (2) Asset Allocation, and (3) Asset Allocation.

The table below confirms this truism by breaking down the determinants of portfolio performance over an average 20-year period:

Determinant Value
Asset Allocation 93.3%
Security Selection 4.6%
Market Timing 2.1%

 

Buy the worst house in the best neighborhood, and there’s a good chance you will make money over the long run because location is the biggest determinant of gains in real estate.

The same applies to financial markets. Investors who pick the right geographies and sectors do best over time, so any opportunity for an investor to focus less time on a specific stock and more on getting the asset allocation correct is in a much better position to perform.

Stock selection only explains 4.6% of the long-term return on an investment but often takes up the overwhelming majority of an investor’s time and resources. Hence, on a time-adjusted basis, stock picking is inefficient and rampant with risk.

Simply put, using ETFs allows investors to put more time and effort into the asset allocation, which more than makes up for the small cost embedded in the product.

The decision to add more ETF exposure in 2015 was predicated upon three key reasons:

  1. Market Evolution: The movements in equity markets over the past year have opened opportunities to move from single stocks to more broad-based investment themes, which experience lower volatility. For example, the Conservative Income portfolio’s volatility has been reduced by close to 40% over the past three months.
  2. Liquidity: Many of the ETFs added are finally liquid enough to meet the strict quality control administered in DIAS. Until recently, these products were too illiquid, but the surge in popularity from large money managers has now made these products big enough to include in the DIAS conservative portfolios.
  3. Turnover: ETF strategies allow for fewer securities in a portfolio, which also lowers portfolio turnover and expected trading costs.

The easiest way to lose money as an investor is to never change a strategy. Markets evolve over time, and those who are not willing to move with these markets will ultimately lose.

The increased use of equity ETFs is a direct result of a change in strategy to adapt to the evolution of the financial markets, and we will continue to assess new products that make the investment process more efficient.

The bottom line is that ETFs have and will likely continue to be an integral component to the investment process, and their benefits to investors far outweigh their negligible fees.

Read this week’s Thought of the Week to learn more about ETFs.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.