Objective information about financial planning, investments, and retirement plans

Dow 18,000 – A Big Deal?

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In February of 2013 I wrote Dow 14,000 – Big Deal or Just a Number?  Today the Dow Jones Industrial Average closed at 17,778 after a 421 point gain.  This is on the heels of a better than 200 point rise yesterday marking the average’s largest two day gain in 12 years.  Dow 18,000 looks like it will not be far off.

Just as I thought Dow 14,000 was a pretty meaningless number, I also think Dow 18,000 is equally meaningless.  In fact there are many, including yours truly, who think the Dow Jones Industrial Average isn’t all that meaningful as a benchmark.

Rather than focusing on the level of the market you should focus on your portfolio and your investment strategy.  Some specific action steps you might consider:

Rebalance your portfolio

You should have a strategy to review your overall portfolio on a regular basis (annually, semi-annually etc.) to ensure that your asset allocation is within your target allocation.  Invariably certain asset classes will outperform or under perform.  Bringing your portfolio back into balance forces you to sell off some winners and fund those asset classes that have underperformed.

Market leaders and laggards shift periodically and this approach adds a level of discipline to your strategy.  Mostly rebalancing helps mitigate investment risk.

Keep expenses low 

You can’t control how the markets will perform.  You can control your investment expenses.  Specifically:

  • Mutual fund and ETF expenses.
  • Trading costs at your custodian.
  • The cost of financial advice

Revisit your investment strategy 

I view market highs as a great time to revisit your investment strategy and your financial plan.  If you’ve been fully and properly invested your portfolio has hopefully risen along with the markets.

Where does this leave you in terms of progress towards achieving your financial goals?  This is a good time to revisit your financial plan.

The Bottom Line

Is Dow 18,000 a big deal?  Not in my book and frankly I wonder if anyone besides the financial news media really cares.  I suggest focusing on the details of your portfolio and your strategy and ignoring the hype.

Check out an online service like Personal Capital to manage all of your accounts all in one place or purchase the latest version of Quicken.  Check out our Resources page for more tools and services.

Tis the Season for Stock Market Predictions

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As I listen to CNBC in the background and read the financial press it is the season for the pundits to make their 2015 stock market predictions.  Some of these predictions relate to the level of the market in general, others include “hot stocks for 2015.”

Many of these people are pretty smart and I’m not dismissing their research.  What I am saying is that that I’m not so sure any of this is useful.  But in the spirit of the season here are my 2015 stock market predictions.

The stock market might go up 

The consensus seems to be that 2015 will be a good year for the stock market.  They might well be right.  The U.S. economy is improving, oil prices are low, etc.

The stock market might go down 

The experts could be wrong or worse there could be some sort of adverse event that spooks the market and perhaps the economy.

My official stock market predication is that I have no clue 

While this is all fun and provides something for the cable news talking heads to discuss, at the end of the day nobody has a clue what 2015 or any year holds for the stock market or the economy.

Focus on what you can control 

We have no control over what the financial markets will do or over how your stocks, mutual funds, ETFs, or any other holdings will do.  But as investors you can control a number of things including:

  • The cost of investment advice
  • The expense ratios of mutual funds and ETFs owned
  • Your asset allocation
  • Your overall investment strategy
  • How much you save and invest in our 401(k) and elsewhere
  • How much you spend.

I’m not denigrating the value of stock market research and analysis.  But for most of you reading this post I’m guessing that you are long-term investors versus being traders.  If that is the case you are, in my opinion, far better off controlling what you can control and investing in line with your financial plan than in trying to chase predictions and hot segments in 2015 or in any year.

Start 2015 out right, check out an online service like Personal Capital to manage all of your accounts all in one place or purchase the latest version of Quicken.  Check out our Resources page for more tools and services.

Is the Dow Jones Industrial Average Still a Relevant Stock Market Index?

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The Dow Jones Industrial Average (DJIA) of 30 large stocks has long been arguably the most watched index for those following the stock market.  As I write this IBM a long-time index component reported a major miss in its quarterly earnings.

The stock was down some 7% for the day and due to this decline the DJIA was been down most of the day.  The index finished up some 19 points but without the drag of IBM the index would have been up around 100 points according to a commentator on CNBC.  This begs the question is the Dow Jones Industrial Average still a relevant stock market index?

It’s just 30 stocks 

The DJIA is a weighted average (the actual weighting formula is very complex) of the price of the 30 stocks that comprise the index.  Originally the index was supposed to represent the stocks of large industrial companies.  Over the years the composition of the index has changed to reflect the changing nature of American business.

Here are the 30 companies that comprise the index:

Company

 

 

 

 

 

3M Co
American Express Co
AT&T Inc
Boeing Co
Caterpillar Inc
Chevron Corp
Cisco Systems Inc
E I du Pont de Nemours and Co
Exxon Mobil Corp
General Electric Co
Goldman Sachs Group Inc
Home Depot Inc
Intel Corp
International Business Machines
Johnson & Johnson
JPMorgan Chase and Co
McDonald’s Corp
Merck & Co Inc
Microsoft Corp
Nike Inc
Pfizer Inc
Procter & Gamble Co
The Coca-Cola Co
Travelers Companies Inc
United Technologies Corp
UnitedHealth Group Inc
Verizon Communications Inc
Visa Inc
Wal-Mart Stores Inc
Walt Disney Co

 

Certainly a nice mix of manufacturers, retail, financial services, and technology related companies.  Three major names absent from the index include Google, Facebook, and Apple.  While these are large and influential companies they do not represent the total focus of the investment universe.

Chuck Jaffe wrote this excellent piece on the topic of the Dow It’s time to ditch the Dow Jones Industrial Average  over at the Market Watch site.

Investing options are varied and global 

Of the major market benchmarks the broader S&P 500 seems to hold a lot more sway with many money managers and others in the finance and investing world.  I know that personally I am a lot more concerned with this index as a benchmark for large cap mutual funds and ETFs than the Dow.

The NASDAQ is also widely watched due to its heavy tech influence.  I think the bursting of the Dot Com bubble put this index on the radar to stay back in early 2000.

Other key benchmarks include the Russell 2000 for small cap stocks, the Russell Mid Cap, the EAFE for large cap foreign stocks and many others for various market niches.  Additionally there are any number of index mutual funds and ETFs that follow these and other key benchmarks for those who want to invest in these segments of the stock market.

While I’m guessing the Dow will remain a widely watched and quoted stock market indicator I and many others find it increasingly irrelevant.  It is always a good idea to benchmark your investments against the appropriate index for a single holding or a blended, weighted benchmark to gauge your overall portfolio’s performance.

Five Things to do During a Stock Market Correction

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As you may or may not know the stock market has been going through some tough days recently.  For example the S&P 500 Index is down about 8% from its all-time high reached in September of this year.  While we are not officially in correction mode (this is usually defined as a 10% or greater drop in an index) there has been a lot of volatility lately.  Here are five things you should do during a stock market correction.

Do nothing

Assuming that you have a financial plan with an investment strategy in place there is really nothing to do at this point.  Ideally you’ve been rebalancing your portfolio along the way and your asset allocation is largely in line with your plan and your risk tolerance.  Making moves in reaction to a stock market correction (official or otherwise) is rarely a good idea.  At the very least wait until the dust settles.  As Aaron Rodgers told the fans in Green Bay after the Packers 1-2 start, relax.  They have since won three straight.  Sound advice for fans of the greatest team on the planet and investors as well.

Review your mutual fund holdings

I always look at rough market periods as a good time to take a look at the various mutual funds and ETFs in a portfolio.  What I’m looking for is how did they hold up compared to their peers during the market downturn.  For example during the 2008-2009 market debacle I looked at funds to see how they did in both the down market of 2008 and the up market of 2009.  If a fund did worse than the majority of its peers in 2008 I would expect to see better than average performance in the up market of 2009.  If there was under performance during both periods to me this was a huge red flag.

Don’t get caught up in the media hype

If you watch CNBC long enough you will find some expert to support just about any opinion about the stock market during any type of market situation.  This can be especially dangerous for investors who might already feel a sense of fear when the markets are tanking.  I’m not discounting the great information the media provides, but you need to take much of this with a grain of salt.  This is a good time to lean on your financial plan and your investment strategy and use these tools as a guide.

Focus on risk

Use stock market corrections and downturns to assess your portfolio’s risk and more importantly your risk tolerance.  Assess whether your portfolio has held up in line with your expectations.  If not perhaps you are taking more risk than you had planned.  Also assess your feelings about your portfolio’s performance.  If you find yourself feeling unduly fearful about what is going on perhaps it is time to revisit your allocation and your financial plan once things settle down.

Look for bargains

If you had your eye on a particular stock, ETF, or mutual fund before the market dropped perhaps this is the time to make an investment.  I don’t advocate market timing but buying a good long-term investment is even more attractive when it’s on sale so to speak.

Markets will always correct at some point.  Smart investors factor this into their plans and don’t overreact.  Be a smart investor.

New Money Market Rules – How Will They Impact You?

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The Securities and Exchange Commission (SEC) recently passed new rules governing money market funds.  These rules are designed to combat liquidity problems should the economy experience another period of crisis such as in 2008.

New Money Market Rules – How Will They Impact You?

I’ve read a few articles on this issue but I do not claim to fully understand all of the implications for investors.  I will likely do a follow-up to this post at some point in the future when I know a bit more. Here are a few items from these new money market rules that might impact you.  You might also check out this excellent piece by Morningstar’s John Reckenthaler.

Floating NAV – Institutional Money Market Funds 

For institutional money market funds the stable $1 net asset value (NAV) per share will be gone.  The NAV of these funds will be priced out to four decimal places and will be allowed to float.  Your shares may be worth more or less than what you paid for them upon redemption.

Again this applies to institutional money market funds.  Retail money market funds, defined as funds owned by natural persons, along with government and Treasury-based money funds will retain their stable $1 NAV.  From what I have been told, money market funds owned by participants within a 401(k) or similar retirement plan are considered to be retail funds as well.  I’m not quite as sure with regard to an institutional share class money market fund held by an individual investor.

Liquidity Fees and Redemption Gates 

Both retail money market funds, again excluding funds investing in government and Treasury instruments and institutional funds, will be subject to liquidity fees and redemption gates (restrictions) under certain circumstances.

  • If liquid assets fall below 30%, a fund’s board may impose a 2% fee on redemptions.  This is at their discretion.
  • If liquid assets fall below 10%, a fund’s board must impose a 1% fee on redemptions.  This fee is mandatory under the new rules.
  • If liquid assets fall below 30%, a fund’s board may suspend redemptions from the fund for up to 10 days. 

How will these new money market rules impact you? 

Money market funds will have two years from the date the final SEC rules appear in the Federal Register to be in compliance with the floating NAV, liquidity fee, and redemption gate rules.

According to Benefits Pro:

“Nearly $3 trillion is invested in money-market funds. As of July 3, 2014, more than $800 billion was held in the institutional money-market funds affected by today’s reforms, according to the SEC.” 

Among the main users of institutional money market funds would be pension plans, foundations, and endowments.  They will be the ones directly impacted by the change to a floating rate NAV; however the beneficiaries of these funds will ultimately be impacted should this change have a negative impact on the underlying portfolio.

The liquidity fees and redemption gates will directly impact individual investors.

A 1% or 2% fee on redemptions would be quite a hit to your balance, especially if viewed in terms of today’s interest rates on money market funds in the range of 0.01%.

The ability to delay redemptions up to 10 days could also have an impact especially if you had written a check off of that account to pay your mortgage or some other bill.

The true test will be if we experience the extreme conditions like those that marked the 2008-09 economic down turn.  None the less as an investor it would behoove you to ask your bank, custodian, or financial advisor how these changes might impact any money market funds you hold and also if it makes sense to switch to another cash option.

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5 Reasons Investors Use ETFs

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Fidelity recently polled nearly 600 high net worth investors to gain a better understanding of their thinking about the market and where they plan to invest in 2014. Notably, 43% of investors said they are planning to increase their investment in ETFs over the next 12 months.

Fidelity created this graphic that highlights 5 reasons investors use ETFs (or don’t use them).

 5 Reasons Investors Use ETFs

Other key findings of the Fidelity study include:

  • Despite the small gains this year in the DJIA (1.6% as of June 5, 2014), 55% believe it will end the year up 5% or more.
  • When it comes to the U.S. economy, investors continue to feel cautious. The majority (71%) feels it’s headed in the right direction vs. 29% who say it’s stagnant or headed in the wrong direction.
  • 62% of investors also believe a market correction—when a major index declines by at least 10% from a recent high—is likely to happen in 2014.
  • The indicators that would motivate the most investors holding cash to re-invest into the market are a stronger U.S. economy (28%) and higher interest (12%). 25% report holding no cash on the sidelines.
  • Over half (59%) of investors prefer to grow their portfolio by investing in domestic equities vs. 18% in international equities.
  • Over a third (35%) invest in ETFs for broad market exposure (indexes), while 27% of investors don’t invest in ETFs because they need to learn more. 

Advantages of ETFs 

ETFs have several features that are advantageous to investors:

  • ETFs are generally transparent regarding their holdings.
  • ETFs can be bought and sold during the trading day.  This offers additional opportunities for investors.
  • Stop orders can be used to limit the downside movement of your ETFs.
  • ETFs can also be sold short just like stocks.
  • Many index ETFs carry low expense ratios and can be quite cheap to own.
  • Many ETFs are quite tax-efficient.
  • ETFs can provide a low cost, straightforward way to invest in core market indexes.  

Disadvantages of ETFs  

  • ETFs can be bought and sold just like stocks.  In some cases this could serve to promote excessive trading that could prove detrimental to investors.
  • ETF providers have introduced a proliferation of new ETFs in response to their popularity.  Some of these ETFs are excellent, some are not.  Many new ETFs are based on untested benchmarks that have only been back-tested.  Additionally there are a number of leveraged ETFs that multiply the movement of the underlying index by 2 or 3 times up or down.  While there is nothing inherently wrong with these products they can easily be misused by investors who don’t fully understand them.
  • Trading ETFs generally entails paying a transaction fee, though a number of providers have introduced commission-free ETFs in order to gain market share.  

ETFs have proven to be a great innovation for investors.  If used properly they are a great addition to your investing toolkit.  Like any investment make sure you understand what you are investing in (and why) before you invest.

Please check out our Book Store for books on financial planning, retirement, and related topics as well as any Amazon shopping needs you may have (or just click on the link below).  The Chicago Financial Planner is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.  If you click on my Amazon.com links and buy anything, even something other than the product advertised, I earn a small fee, yet you don’t pay any extra. 

Are Alternative Investments the Right Alternative for You?

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Alternative investments are all the rage these days.  Mutual fund companies are falling all over themselves to sell financial advisors and their clients on “liquid alts” or hedge fund-like strategies with the daily liquidity offered in a mutual fund wrapper.  Hedge funds were allowed to advertise due to a change in the rules last year.  The financial press is filled with articles about alternatives and the fund companies are offering numerous webinars and conferences covering them.

Are alternative investment strategies right for your portfolio?  I have no idea but here are some questions to ask as well as some information for you to consider.

What is an alternative investment strategy?

Alternatives are basically investment vehicles that aren’t purely stocks, bonds, or cash. The purpose of alternatives is generally to diversify an investment portfolio.  Ideally these strategies will have a low correlation to other investment vehicles in your portfolio.  Examples of alternative strategies include:

  • Hedge funds
  • Unconstrained fixed income
  • Macro strategy funds
  • Commodities and managed futures
  • Real estate
  • Precious metals
  • Long/short equity
  • Convertible arbitrage
  • Private equity
  • Vulture funds
  • Venture funds
  • Merger arbitrage 

As mentioned above, these strategies are available in the more traditional hedge fund format, as mutual funds, ETFs, and as fund of funds in each of these formats.

Consider this before investing in alternatives 

Before buying an alternative fund or product here are a few questions to consider:

  • Do you understand the underlying investment strategy?
  • What benefit will this investment provide to your overall portfolio?  Reduced volatility?  Low correlation to other holdings?
  • What are the expenses? Are they justified given the expected benefit of investing in this alterative fund?
  • Are there any restrictions on redeeming your investment? Typically (but not always) with a mutual fund or ETF the answer is no, hedge funds may have a lockup period or other restrictions.
  • Have this fund’s performance been tested in real market conditions or just back-tested on a computer?
  • Who’s managing the fund?  What is their background and track record? 

I am actually a fan of alternatives and have used several mutual funds of this type for a number of years.

Remember though, large endowments like those of the Ivy League schools use alternative investments extensively and successfully.  Unlike you they have access to the expertise needed to perform proper due diligence. Does the financial advisor recommending these funds to you really understand them? Be sure that you do before investing in any alternative investment product.

Please check out our Book Store for books on financial planning, retirement, and related topics as well as any Amazon shopping needs you may have (or just click on the link below).  The Chicago Financial Planner is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.  If you click on my Amazon.com links and buy anything, even something other than the product advertised, I earn a small fee, yet you don’t pay any extra. 

 

Please contact me at 847-506-9827 for a complimentary 30-minute consultation to discuss all of your investing and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services

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Peyton Manning and Investing Success

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I attended the Envestnet Advisor Summit at the Chicago Hilton this past week.  Excellent conference, Envestnet offers a robust platform for financial advisors.  A colleague urged me to attend and I’m glad I did.

The highlight of the conference was Peyton Manning’s keynote address on Friday morning.  Regular readers here know that I am diehard fan of the Green Bay Packers, but I think all football fans have to respect Manning’s skill and his character.  His address was about leadership and being a game changer.  I felt that several of his remarks and comments have a direct correlation to being a successful investor.

Peyton Manning

Thrive on discomfort 

Manning made this reference in terms of it being a key trait of game changers.  I think this is a key trait of successful investors as well.

The investing landscape has certainly undergone change and disruption since the beginning of this century.  We’ve experienced the bursting of the Dot Com Bubble, the financial crisis of 2008-09, the Flash Crash and many other disruptions.

Successful investors adapt to change and embrace it to their advantage.  In some cases this means knowing when to change their investing style, in others it means knowing when to stay the course.  It also means knowing how and when to use new investing tools like ETFs and others.

Ask questions 

Manning mentioned this as a key trait of leaders in business and something that he does constantly in an effort to guide his team to even greater levels of success.

Investors should always ask questions.  Some key questions include:

  • Would I buy this particular investment today?
  • Is there a better place for my money?
  • What are your conflicts of interest in terms of advising me to make this investment?
  • How does this investment fit into my overall portfolio?  

It’s over move on after a bad play

Manning cited the uncanny ability of 49ers great Joe Montana to lead his team to a touchdown on the series immediately following his having thrown an interception.

This is a key trait for successful investors to adopt.  I can’t tell you how many investors I’ve spoken to who want to hold a losing position until it breaks even.  The ability to accept an investment loss is critical.  Sometimes it is better to realize a loss and reinvest the proceeds elsewhere.  Even the best investors make bad investing bets.  The successful ones are capable of admitting this and moving on.

Invest in a coach to keep you growing

Manning hired the current Duke Head Football Coach as his offseason coach to help him improve his quarterback skills.  This individual was his offensive coordinator in college at Tennessee.  This is Peyton Manning, 5 time MVP and Super Bowl champion hiring a coach to help him improve his game!

Many investors do a great job of accumulating wealth and managing their investments.  At some point even the most successful ones realize that they might need some outside expertise to take things to the next level.

Perhaps this realization comes as their career and family obligations limit the time they can spend on their investments.  Often this realization comes as retirement approaches.

Hiring a financial advisor is not a sign of weakness; rather it is a sign that you realize the limits of your expertise and the best uses of your time.  If you are at this point here is a guide to choosing a financial advisor that might help you.

Peyton Manning spoke about leadership and did a great job of tying in his experiences as a leader in sports to what financial advisors need to do to lead clients to the successful outcomes they are seeking.  As I listened to him speak I couldn’t help but see the relevance of his message to what I believe it takes to be a successful investor in today’s dynamic investing world.

Please check out our Book Store for books on financial planning, retirement, and related topics as well as any Amazon shopping needs you may have (or just click on the link below).  The Chicago Financial Planner is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.  If you click on my Amazon.com links and buy anything, even something other than the product advertised, I earn a small fee, yet you don’t pay any extra. 

Please contact me at 847-506-9827 for a complimentary 30-minute consultation to discuss all of your investing and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.

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Investing: Time and Diversification are your Friends

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Each quarter Dr. David Kelly and his staff at JP Morgan Asset Management publish their Guide to the Markets.  This is a comprehensive chart book of investment and economic data that I find invaluable.

For the past several quarters the Guide has included this chart which as a long-term investor should be quite important to you.
 


The chart depicts the range of average annual returns for stocks, bonds, and a combination of the two over rolling 1, 5, 10, and 20 year periods from 1950 through 2013.  In my opinion every investor should understand the impact of diversification and time on their investments as depicted on the chart.

Understanding the chart 

The green bar depicts stocks, the light blue bar depicts bonds, and the grey bar depicts a 50-50 mix of the two.

As you can see the greatest volatility of return occurs over rolling 12 month periods.  The range of a 51% gain to a 37% loss in a 12 month period is huge.  The range for bonds is more compact and the range for a 50-50 mx of stock and bonds is slightly more compact.

As you move out to the 5, 10, and 20 year ranges you will note that the ranges from the largest gains to smallest (or a loss) become smaller with the passage of time.

Also of note is that in no 5, 10, or 20 year rolling time frame depicted does a 50-50 mix of stocks and bonds result in a negative return over the holding period.

What does this mean to you as an investor?

Diversification dampens the variability of your returns. As you can see from the chart stocks have a wider range of returns over all of the periods depicted than do bonds.  Combining the two tends to dampen the volatility of your portfolio.  Further enhancing the benefits of diversification is the fact that stocks and bonds are not highly correlated.

Taking this a step further, while an investment in an index mutual fund like the Vanguard 500 Index (VFINX) would have lost money if held over that 10 year period 2000-2009, a portfolio that was diversified to include fixed income, small and mid-cap funds, international equities, and other asset classes would have recorded gains during that same time period.

Time reduces the volatility of returns. I will leave any scientific explanation to those more attuned to this than myself, but certainly part of the reason are the ebbs and flows of market and business cycle factors that have an impact on stocks and bonds.  These might be recessions, interest rate movements, or other factors.

Implications for the future

The performance and characteristics of stocks and bonds might well differ in the future.  Diversification for most investors will likely mean holding more than just Large Cap domestic stocks and Intermediate Bonds as the graph depicts.  A few thoughts for the future, especially in this market environment of record highs for many stock market indexes:

  • Diversification reduces risk.
  • Diversification among assets with low correlations to one another further reduces risk.
  • Diversification is important because we have no way of knowing which investments or asset classes will perform well or poorly or when.
  • A longer holding period will generally serve you well as an investor in terms of smoothing out portfolio volatility. 

While every investor is different as is every investment environment, diversification and patience can be two of your greatest allies.

Please contact me at 847-506-9827 for a complimentary 30-minute consultation to discuss all of your investing and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.

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What Do ETFs and Youth Soccer Have in Common?

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Another sign of spring here in the Chicago area is the appearance of lines on the local youth soccer fields.  All three of our kids played soccer and we still miss watching them play.

So what do ETFs and youth soccer have in common?  From our experience as the parents of three travel soccer players, including one who was a ref for several years, very few parents understand the rules of the game which sadly too often leads to some really bad behavior on their part.  From many of the questions that I get and from what I read many investors don’t understand ETFs all that well either.  This post will attempt to highlight some of the basics of ETF investing for those readers who may be unclear or have a few questions.

(One example of some over the top soccer parents occurred when our now 23 year daughter was playing in a 9 year old game.  Some parents from the other team came over to our side of the field and started a fight.  My wife ended up as a witness in soccer court and two dads ended up being banned from any Illinois youth soccer game or practice for two years.) 

 

 

What is an ETF? 

According to the NASDAQ site:

“In the simplest terms, Exchange Traded Funds (ETFs) are funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index, but simply replicate its performance. They don’t try to beat the market, they try to be the market. 

ETFs have been around since the early 1980s, but they’ve come into their own within the past 10 years.”

In simple terms ETFs are essentially mutual funds that trade on the stock exchanges much like shares of common stock such as Apple or IBM.  They are bought and sold during the trading day just like stocks.

While it is true that the first ETFs were index tracking products, actively managed ETFs are coming into play with perhaps the most successful active ETF so far being the ETF version of PIMco’s Total Return bond fund (ticker BOND).

Advantages of ETFs 

ETFs have several features that are advantageous to investors:

  • Most ETFs are transparent as to their holdings.
  • ETFs can be bought and sold during the trading day.
  • Stop orders can be used to limit the downside movement of your ETFs.
  • ETFs can also be sold short just like stocks.
  • Many of the index ETFs carry low expense ratios and can be quite cheap to own.
  • Due to their structure, many ETFs are quite tax-efficient.
  • ETFs provide a low cost, straightforward way to invest in core market indexes. 

Disadvantages of ETFs 

  • ETFs can be bought and sold just like stocks.  In some cases this could cause investors to trade in and out of ETFs when perhaps they shouldn’t.
  • The popularity of ETFs has caused ETF providers to introduce a proliferation of new ETFs, some are excellent, some not so much.  Many new ETFs are based on untested indexes that have only been back-tested.  Additionally there are a number of leveraged ETFs that multiply the movement of the underlying index by 2 or 3 times up or down.  While there is nothing inherently wrong with these products they can easily be misused by investors who don’t fully understand them.
  • Trading ETFs generally entails paying a transaction fee, though a number of providers have introduced commission-free ETFs in order to gain market share. 

All ETFs are not created equal 

Much of the growth in ETFs was fueled by basic index products such as the SPDR 500 (ticker SPY) which tracks the S&P 500 index.  Vanguard, ishares, and the SPDRs all started with products that tracked core domestic and international stock and bond indexes.  The popularity of ETFs grew in the wake of the financial crisis and ETF providers have been falling all over themselves to bring new ETFs to market.

Some of these new vehicles are good, but others track questionable indexes or benchmarks.  These products are essentially made up in a lab, reminiscent of Gene Wilder, Terri Garr, and Marty Feldman in Young Frankenstein.

There is a site with an ETF Deathwatch section listing various ETFs and other exchange traded products that are on life support.  This Bloomberg article comments on some ill-fated ETFs as well.

Free trades are good or are they? 

Fidelity and Schwab most notably have offered platforms that allow commission-free ETF trades for their own branded ETFs and a select menu of other ETFs.  This is fine as long as these are the ETFs that you want to own.  Note I’ve found that several of the Schwab ETFs are very low cost and track core indexes so they can be good choices.

Additionally you can trade Vanguard’s ETFs commission-free if you trade in an account at Vanguard.

At the end of the day you should buy the ETFs that are best for your situation.  This assessment should include the underlying ETF benchmark, the expense ratio, and the liquidity.  If you can trade it commission-free so much the better.

Overall ETFs can be a great investment vehicle for both traders and long-term investors.  As with any investment vehicle it is incumbent upon you to understand what you are buying and how it fits into your investment strategy.

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