Objective information about financial planning, investments, and retirement plans

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.

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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ETF Price Wars: A Good Thing or Just More Hype?

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Fidelity has fired another salvo in the ongoing ETF price wars with the introduction of a number low cost sector ETFs.   Schwab, TD, Blackrock, Vanguard, and others have also participated in this price war in one form or another over the past couple of years.  Low ETF expenses and low or no transaction fees are a good thing, but should they be the deciding factor in your decision where to invest?

Walmart on Black Friday 2009

Understand what you are buying 

As we’ve learned from the PBS Frontline special The Retirement Gamble among other sources, low investment costs are a key determinant accumulating a sufficient retirement nest egg.  The first and most important factor in choosing an ETF to include in your portfolio is to understand what the ETF invests in.

An ETF that tracks an index such as the S&P 500 is pretty simple.  However ETF providers are introducing new products seemingly every day.  According to Chuck Jaffe in a MarketWatch article, a Vanguard report found that “1,400 U.S. listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.”

Beyond commissions and expense ratios 

Fidelity recently published an excellent piece on its site, Beyond Commissions: An ETF’s Price Matters.  According to the article:

“Commissions aren’t the only cost to consider when buying an ETF. Most investors compare expense ratios, but a less appreciated—yet important factor—is the bid-ask spread, which is the difference between the highest price a buyer is willing to pay for an asset (bid) and the lowest price at which a seller is willing to sell (ask). While investors should consider the Net Asset Value (NAV) of an ETF, the price you pay is a seller’s ask price, which can be at a discount or premium to the NAV.

“It’s important to remember that not all ETFs are created equal,” says Ram Subramanium, president of Fidelity brokerage services. “So, investors may want to look for ETFs with established track records and low bid-ask spreads relative to their peers.”

As an interesting aside here, one of the low cost sector ETFs that Fidelity recently introduced was its materials ETF Fidelity MSCI Materials ETF (FMAT).  This ETF competes directly with the Vanguard Materials ETF (VAW) and has an expense ratio of 0.12% vs. 0.14% for the Vanguard ETF.  However the recent bid/ask spread for the Fidelity ETF was 11.68% vs. 1.57% for the Vanguard ETF (according to Morningstar).  The passage above from the Fidelity article might indicate that the older, more established Vanguard ETF is a better choice here.

Other factors to consider

  • Unless you are a frequent trader or you are purchasing ETFs in small dollar amounts trading commissions really shouldn’t be a major factor in your ETF investing decisions.
  • Consider the full breadth of the investment products available to you as well as your investing objectives when choosing an investment custodian.  ETF price wars are much like loss leaders in retailing.  Major custodians such as Fidelity are using low cost ETFs to get you in the door and to hopefully entice you to use their services to invest in mutual funds, stocks, and other investment products via Fidelity.
  • Are the commission-free ETFs the right ones for your portfolio?  For example a number of the ETFs offered on Schwab’s commission-free platform are not ones that I would generally choose for my client’s portfolios.
  • How cheap is cheap?  I doubt that selling one ETF and buying another to save say 0.02% on the expense ratio makes sense, especially if there are transaction costs or capital gains to consider when selling.
  • How well does the ETF track it’s benchmark index?  I’m often surprised by the variations when comparing two ETFs that I would assume to be identical other than the name of the ETF provider.

Are ETF price wars a good thing for investors?  Yes.  Are ETF price wars being used by major custodians and ETF providers to create hype in the financial press in order to lure investors?  Again yes.  The bottom line here is that your financial plan and investment strategy should guide your choice of ETFs, mutual funds, or any investment vehicle, not a slightly lower cost or the lure of free trades.

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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5 Things You Should Know About ETFs

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English: Wall Street sign on Wall Street

ETFs continue to gain ground as an investment of choice among many individual and institutional investors.  ETFs are similar to mutual funds in that they are pooled investment vehicles and to closed-end funds in that they are traded on a stock exchange like individual stocks.  ETFs, though popular, are often misunderstood by investors.  Here are 5 things you should know about ETFs.

Not all ETFs use conventional underlying benchmarks

The first ETFs were largely index products such as the SPDR S&P 500 (ticker SPY) which tracks the S&P 500 index.  SPY remains one of the most traded ETFs day and day out in terms of volume.

An ETF like SPY is pretty easy to understand.  The underlying holdings mirror the S&P 500 index and performance generally tracks the index less the ETF’s expenses (0.09% according to Morningstar).

With the popularity of ETFs, the growth and proliferation of new vehicles is quite high.  Many of these new ETFs track some “funky” benchmarks.   Market Watch’s Chuck Jaffe cited a Vanguard report that found “1,400 U.S. listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.”   

I suspect this issue will become more prevalent as ETF providers continue to introduce new ETFs in a bid to capture market share and assets.

Some ETFs are based on fads or gimmicks 

The Winklevoss twins (of Facebook fame) recently announced the proposed launch of a new ETF tracking Bitcoin.  Bitcoin is virtual currency that exists outside of governmental regulation.  The ETF faces many hurdles and may never get off of the ground.

Should the ETF ever become available for trading this would be the ultimate in gimmicky ETFs.  I find Bitcoin itself a bit hard to understand.  An ETF tracking this at best undeveloped market would in my mind be a stretch.  As an investor this is the type of ETF that I would seriously question.

There are any number of ETFs and other Exchange Traded Products (ETPs) that just don’t work out.  You can find many of these on the monthly ETF Deathwatch listing.

ETF Liquidity is complicated.

With stocks liquidity and the trading volume of the equity are closely correlated.  While a thinly traded ETF might result in a little less liquidity the real determinant of liquidity with an ETF is the liquidity of the underlying investments that make up the ETF.

For example the SPDR S&P 500 is made up of the 500 largest domestic stocks.  These stocks are highly liquid and generally all have substantial daily trading volume.

By contrast we’ve seen some fairly wide spreads between the underlying net asset value and the market prices of some emerging market ETFs of late.  This is in large part a function of a lack of liquidity of the underlying holdings of these ETFs.

Not all ETF structures are identical

Vanguard’s ETFs are structured as another share class of their mutual funds in most cases.  Many popular ETFs are structured as open-end funds, others are structured as Unit Investment Trusts (UIT).  Many single commodity ETFs are structured as Grantor Trusts.  Exchange Traded Notes (ETN) are actually debt instruments linked to the performance of a currency, a commodity, or an index.

Each of these structures have different characteristics and these characteristics may have an impact on the tax treatment of gains or distributions.  For example some commodity based ETFs have a different ongoing tax treatment than say an equity-based index ETF.

It is important that you understand any such factors of your ETF or ETN to avoid nasty surprises at tax time or undo risks that may be associated with the product’s structure. 

Free commission ETFs may not be the best deal for you 

Schwab, Fidelity and others are offering a number of ETFs that trade commission free.  That’s a good thing, but before jumping on one these offers make sure the ETFs offered for free are the best deal for you.

The benefit of free commissions can quickly be negated by high ongoing expenses.  Trading costs are relatively low at most online and discount brokers so unless you are a frequent trader this really shouldn’t be a factor in the decision as to which ETFs belong in your portfolio.

Additionally buying an ETF that doesn’t fit your investment objectives just to save a few dollars in trading costs is absurd.

ETFs can offer a low cost vehicle to build a portfolio.  I use index ETFs extensively for their low costs and adherence to an investment style as a key building block in my client asset allocation strategies.

Like anything else, however, it is vital that you understand what you are buying and that you invest in ETFs that are appropriate for your investment plan.

I want to thank local ETF expert Christian Magoon for his contributions to this post. 

Please contact me at 847-506-9827 for a free 30-minute portfolio review consultation and 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.   

For you do-it-yourselfers, check out Morningstar.com to analyze your ETF and all of your investments and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.  

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Pens, Trinkets, and Mutual Funds

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McCormick Place

With the annual Morningstar Investment Conference coming up here in Chicago next week, my thoughts naturally gravitate to replenishing my office supply of high quality pens in the exhibit hall at McCormick Place.  Truth be known, my thoughts are more focused on preparing for my participation on a panel on Friday morning called Practical Solutions for a Challenging Retirement Landscape.  Morningstar’s superstar financial author and columnist Christine Benz was kind enough to invite me to participate in this discussion along with representatives from T. Rowe Price and Vanguard.

Pens and Trinkets

Ever since the first financial conference I attended in the mid 1990s I’ve never ceased to be amazed by the number of items that mutual fund providers and other financial services vendors can find to stick their names and logos on.  When my kids were younger they were the only ones in their school with backpacks from places like the Philadelphia Commodity Exchange and the London Stock Exchange.

At one point I had a whole section of T-shirts from defunct mutual fund companies like Strong and Berger.  Add an infinite number of logoed tote bags and baseball hats and you get the picture.  Our kids always liked the stress balls I found at many of the booths (we were obviously tough parents).

In recent years I’ve tried to be more practical at Morningstar and other conferences and focus on gathering a supply of pens for the office.  I always grab as many as I can because my wife and kids always seem to be on the prowl for these as well.

While strolling around the exhibit hall at last year’s conference I was really making a great haul on pens when it suddenly hit me:  There are a lot of companies that offer mutual funds and I’ve never heard of many of them.  And I’m a financial advisor.

How many mutual funds are there? 

According to the Investment Company Institute there were 7,596 mutual funds at the end of 2012.  This is down from the high of 8,305 at the end of 2001.  Add in 602 closed-end funds and 1,194 ETFs and there are lots of choices for investors.

How do you choose the right funds? 

Any selection of mutual funds, ETFs, or any other investment vehicle should start with an investment plan, which is ideally an outgrowth of your financial plan.  Once you have an asset allocation strategy you will want to fill these allocation buckets with funds and ETFs that are appropriate for your situation.

Here are six mutual fund selection mistakes to avoid:

  • Assuming that a “brand name” fund from a well-known fund family is automatically a good investment choice.
  • Relying on lists of top mutual funds from popular magazines or websites.
  • Ignoring a fund’s history.
  • Avoid mutual funds from fund issuers that you’ve never heard of.
  • Assume that all index funds are created equally.
  • Assume that mutual fund companies automatically have your best interests at heart.

Some additional considerations in selecting mutual funds and ETFs:

  • Expenses matter.
  • When using an index product make sure that you understand what index the fund is tracking and that it tracks that index closely.
  • Avoid actively managed funds that are nothing more than closet indexers.
  • When building a portfolio understand the concepts of diversification and correlation.
  • Understand why you are choosing a given fund or ETF, where it fits in your portfolio, and what would cause you to eliminate this holding.

The Morningstar Investment Conference is a great place to catch some excellent educational sessions and to talk to fund and ETFs issuers to learn about their products.  I would be remiss in not mentioning the great work done by Leslie Marshall and her team from Morningstar in staging this conference.  The fact that it always runs smoothly is a tribute to Leslie’s organizational and management skills.

Please feel free to contact me with your investing and financial planning questions.  Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.   

For you do-it-yourselfers, check out Morningstar.com to analyze your mutual funds and ETFs and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.  

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Investing: Even Indexing Takes Work

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INDEX IIM Lucknow Logo

The benefits of low-cost index mutual funds and ETFs are all over the news.  They were front and center in the recent PBS Frontline Special The Retirement Gamble.  Index funds are a great tool for investors of all ages; in many cases these passively managed funds beat the majority of their actively managed peers within the same investment style.  However, investing in index funds takes work, especially with the proliferation of new index products that continue to hit the marketplace.

Expenses matter 

Costs matter when investing.  One of the biggest lures of index fund investing is that many of these products provide a low cost way to investment in a given segment of the market.  If you are looking for an index fund that mimics the S&P 500 there are many great low cost alternatives such as the Vanguard 500 Index Fund (Ticker VFINX) with an expense ratio of 0.17% or the SPDR S&P 500 Index ETF (Ticker SPY) with an expense ratio of 0.09%.  On the other hand, there is also the Rydex S&P 500 A (Ticker RYSOX) with its expense ratio of 1.51%.  How big of a deal is this difference?

A $10,000 investment in the Vanguard 500 fund made on May 31, 2006 and held until May 15, 2013 would now be worth $15,064.  That same investment in the Rydex S&P 500 fund would be worth $13,798 or 9.2% less for an investment in a mutual fund tracking the same index as the Vanguard fund. 

Understand the underlying index 

In the wake of the 2008-2009 market downturn new index products, especially in the ETF space, have proliferated.  ETF providers are falling all over themselves to bring new index products to the market hoping to attract assets.  Like any investment, investing in an index fund or ETF requires that you understand what it is that you are buying.

When I think of indexing I think of the traditional, basic index products that track benchmarks such as the S&P 500, the total U.S. stock market, the total non-U.S. market, the domestic bond market, etc.  Additionally I typically use index funds to benchmark the U.S. small and mid cap equity spaces, real estate, and emerging markets equity among others.

Several months ago Market Watch’s Chuck Jaffe cited a Vanguard report that found “1,400 U.S. listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.”  

As an investor this should be a huge red flag.  What this study says is that many of these new index products were developed much like the monster in the Mel Brook’s classic Young Frankenstein.  Look back-testing is not inherently bad and many of these new index products are appropriate for professional traders.  However if you are looking to index in the fashion that Vanguard founder John Bogle and others espouse then you should consider sticking with index products that track known, battle-tested market benchmarks.

Asset allocation is still vital 

Whether you use index products as a portion of your overall portfolio in conjunction with other investment vehicles such as actively managed mutual funds or individual stocks, or if you invest in index funds exclusively you still need to develop and asset allocation for your portfolio.  As I say frequently on this blog, this should be done as an outgrowth of your financial plan.

Even a seemingly simple strategy of investing in a total U.S. stock market fund, a total international stock market fund, and a total bond market fund still requires that you determine how much to invest in each fund, that you monitor your allocation and rebalance when needed, and that you review and adjust your target allocation as you age or if your situation changes.

Index funds and ETFs are a great investment tool.  Like any tool it is important that you select the right index product and that you manage your portfolio properly.

Please feel free to contact me with your investing and financial planning questions.  Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.  

For you do-it-yourselfers, check out Morningstar.com to analyze your index mutual fund and ETF options and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.  

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Winning The Retirement Gamble: Step 1 Adjust Your Mindset

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Tri-Athletes Mental Tool Box -- F.A.S.T.

The PBS Frontline documentary The Retirement Gamble has sparked a lot of discussion, both pro and con.  One thing that is clear, the show contributed to the discussion about the lack of retirement readiness among many in the United States.  I’m hardly an expert in behavioral finance, but I do know that in order for investors to be able to focus on planning for their retirement they need to adopt  the right mindset.

Lose the victim mentality

I saw a lot of this on the PBS special and see this written about frequently in the press.  The last few years especially have been rough on many of us saving for retirement.  Job losses; the financial crises; the Flash Crash; the realization that not all financial advisors have their client’s best interests at heart; the mutual fund scandals of the middle part of the last decade might all be good excuses to feel like a victim.

As my wife used to say to our kids on the soccer field (when they had a minor injury) “…suck it up and get back in the game…”  If you feel like a victim you likely will end up as one.  Right or wrong saving for retirement is on you, deal with it.

Drink your own flavor of Kool Aid 

I love index funds and ETFs and use them extensively throughout my practice.  They comprise the majority of the assets for which I provide advice.  I don’t, however, use passive index products exclusively.  There are solid actively managed funds that in my opinion warrant inclusion in some client portfolios.

There are some folks out there who have an almost cult-like devotion to indexing and John Bogle.  Mr. Bogle deserves all of the respect and admiration that he gets and then some.  My point is that no single way of doing things is always right in all cases.  It’s OK to mix and match funds, ETFs, active, and passive strategies, as well as other vehicles as long as they fit your financial plan and your needs.  Don’t let anyone put you down because you disagree with their way of doing things.

Focus on the future, don’t dwell on the past 

The past is in the books.  Maybe you didn’t save enough perhaps you invested in all of the wrong places.  Perhaps you had a greedy “financial guy” whose focus was on selling you products that enriched their bottom line at your expense.  Don’t forget your past mistakes, learn from them, but don’t dwell on them.

All you can do in the financial planning and investing world is move forward from wherever you are now.

  • Find a fee-only financial advisor who puts your interests first.
  • Get a financial plan in place with appropriate goals and strategies.
  • Review your investing strategy.
  • Beef up your retirement savings.
  • Manage your career.
  • Take charge

Our retirement savings system puts the responsibility for accumulating enough for retirement on us.  Get in the game make sure you have the right mindset and attitude to be successful.

Please feel free to contact me with your financial planning and investing questions.  Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.  

For you do-it-yourselfers, check out Morningstar.com to analyze your investment holdings and your portfolio. Please click on the link to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you. 

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Friday Finance Links March 8, 2013 – Late Winter Edition

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Understanding your retirement
 

The almost 10 inches of snow we received earlier in the week should mostly be gone with temperatures forecast to be near 50 over the weekend.  Maybe spring is really near.  Tonight we are having dinner with two of our kids.  Tomorrow my wife, one of our daughters, and I will be doing some volunteer work at a local food pantry.

Here are a few links to some great weekend financial reading. 

Personal Finance Blogs 

Mike explains What is a Closed-End Fund? at Oblivious Investor.

Ken tells us How to Learn From Your Investment Mistakes at AAAMP Blog.

Kay reminds us Don’t forget about your traditional or Roth 401(k) at Don’t Mess With Taxes. 

Posts from Fellow NAPFA Members 

Sterling Raskie tells us Why You Need an Emergency Fund  at Getting Your Financial Ducks in a Row.

Mathew Illian shares Two Disclosed And One Hidden Cost Of ETFs at Figuide.com.    

Other financial articles from around the web

Josh Brown wrote this excellent piece about investing at market highs Wrong Question at Reformed Broker.

Elizabeth O’ Brien tells us Women face a new long-term care dilemma at marketwatch.com.

Christine Benz shares The Error-Proof Portfolio: Should You Rebalance Into (Gulp) Bonds? at morningstar.com (Thanks to Christine for quoting me in this piece).

Emily Brandon outlines 7 Obstacles to Saving for Retirement at usnews.com.

In case you missed it here is my latest post for the US News Smarter Investor Blog Is the Dow Record a Big Deal? 

Here’s wishing everyone a great weekend.

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Do Index Funds Reduce Investment Risk?

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Index mutual funds and ETFs (we will refer to them as index funds unless otherwise indicated going forward in this article) have received a lot of favorable press of late.  This is justifiable as index funds offer a low cost way to invest and are generally quite specific to a given investment style.  Over the years I have been asked if index funds reduce investment risk.  Let’s examine this question.

Illustration of Standard deviation

What is investment risk? 

One definition of  investment risk as the variability of the investment’s returns also known as standard deviation.   Note variability means returns that are both higher and lower than the fund’s average returns over a given period, say the trailing three or five years.

I contend that most investors would define investment risk as the risk of losing money on an investment.  This is especially true in the wake of the recent financial crises.

An index fund takes on the risk of the underlying index it tries to replicate. For instance, in 2008 the S&P 500 Index lost 37 percent. There are many funds and ETFs that track that index. They all lost around 37 percent plus the fund’s expenses. For example, the Vanguard 500 Index Fund (symbol VFINX) posted a loss of 37.02 percent for the year.

Active management vs. index funds 

Let’s take a look at several of Morningstar’s analyst favorites in the Large Growth style compared with an index fund in this style and with the S&P 500 index.

10 yr. Standard Deviation

10 yr. mean return

Vanguard Growth Index (VIGRX)

+/-15.14%

8.10%

Jensen Quality Growth (JENSX)

+/-13.19%

6.62%

Vanguard Primecap (VPMCX)

+/-15.50%

10.83%

Harbor Capital Apprec. (HACAX)

+/-15.57%

8.65%

S&P 500 Index

+/-14.80%

7.93%

Data from Morningstar.com

In plain English, the Vanguard Primecap fund posted an average annual return of 10.83% over the trailing ten years depicted.  Based on fund’s standard deviation of +/- 15.50% one would expect the fund’s returns to range between -4.67% and +26.33%.

The bigger take away from this chart is that the Vanguard Index fund’s volatility was lower than a couple of the funds and higher than Jensen.   As with any index fund the Vanguard fund experienced approximately the level of risk and return of its underlying index, other actively managed funds in this category experienced more or less risk and return based upon the stock selections of the managers.

Manager Risk 

Index funds can eliminate manager risk, or the risk of investing in an actively managed fund only to see the manager underperform the benchmark index.  As an example for the trailing periods ending January 31, 2013 the Vanguard Growth Index outperformed 83% of the other Large Growth funds for the trailing three years; 84% of the other fund for the trailing five years; and 61% of the other fund for the trailing ten years.

This is not to say this will be the case with all index funds over all periods of time. However, a well-run index fund should track its underlying index closely and deliver index-like performance.

Several years ago an instructor at a continuing education session indicated that many of the actively managed mutual funds atop the 10-year rankings in their respective categories most likely spent three of those calendar years in the bottom quartile of their category rankings. For an investor who held one of these funds over that entire 10-year period this isn’t a problem. But investors who bought into such a fund at a different time or over various periods of time may have had quite a different experience.  As we know, money tends to chase performance, hot funds attract investor dollars, funds that are struggling tend to see more client redemptions.  This is so prevalent that Morningstar measures investor performance along with the actual performance of the mutual fund.  Investor performance provides a measure of how actual investors fared by investing in this fund, including the timing of investments and redemptions.  In many cases investor performance varies significantly from the actual fund returns.

A few other points to consider: 

Expenses matter

You should generally buy the cheapest index fund that tracks the index you are interested in. There is a huge disparity in the fees for funds that track the S&P 500 for example.

Understand the underlying index.

There has been a proliferation of new index ETFs tracking a variety of indexes. In many cases I have never heard of many of these indexes. Make sure the index tracked by the fund or ETF you are considering makes sense for your overall portfolio and that the index has a real history not just some back-tested data behind it.

Using index funds is no guarantee of investment success

Just like with any mutual fund or ETF, how you use these products is the key to your success. Index funds are nothing more than a building block to construct your portfolio.

Don’t dismiss active managers  

Evaluate actively managed funds and understand why they have been successful in the past and in what types of environments they might lag their peers. Moreover, carefully think through the role the fund might play in your portfolio, and be aware of who is managing the fund. Is the same person or team that actually compiled the impressive track record still in charge? Or has this manager moved on, placing the fund in the hands of some new, unproven manager?

Index funds do not necessarily reduce investment risk or guarantee a higher investment return than using actively managed funds.  Like anything in the investment world, investing with a strategy (ideally tied to your financial plan), monitoring your results, rebalancing your allocation, and making adjustments to your portfolio when warranted are still key elements in successful investing.  Index funds are simply a tool you can use in this process.

Feel free to contact me with your investment and financial planning questions.

For you do-it-yourselfers, check out Morningstar.com to analyze your mutual funds and all of your investments and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.

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E*Trade’s Fee Commercials – Informative or Misleading?

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During the Super Bowl I watched E*Trade Financial’s commercials deriding the 2% (of assets under management) fees they claim are charged by many financial advisors and portraying their advice services as the white knight answer to this problem.

Are these commercials informative?  

I say yes in that they focus on the issue of fees for financial advice.  Fees for investment vehicles such as mutual funds as well as for financial advice have come under scrutiny of late which I think is a good thing.  Any advisor who is charging 2% is charging too much.  That said I am not aware of any advisors who actually charge this much, but I’ll give E*Trade the benefit of the doubt on this.

Are these commercials misleading?  

Again the answer, in my opinion, is yes.  There are many questions that I have such as:

  • How many advisors actually charge 2%?
  • What types of services are we talking about?  Investment advice only?  Wealth management?
  • What is included in the 2%?  I’m assuming this is only the actual fee charged by the advisor and not the expense ratios of mutual funds or other investment vehicles.

In any event I feel that E*Trade was conveniently vague here.

What does E*Trade’s Financial Advice Cost?

Here’s what I found looking around their site:

Managed Investment Portfolios $25,000 minimum

Managed Investment Portfolios are actively managed discretionary portfolios of leading mutual funds or ETFs, rigorously researched, selected, and optimized by a team of experienced investment professionals. We’ll help you choose the portfolio that’s right for you. 

To me this sounded a lot like what the brokerage firms call a wrap account, which in fact I found that this was when I read the fine print on the site.  Some portfolio manager (who E*Trade describes as “E*TRADE Capital Management, LLC, a registered investment advisor, manages the Managed Investment Portfolios program. Our investment committee and a team of analysts develop investment portfolio models and evaluate individual investments in accordance with various macroeconomic factors, fund and security data, and proprietary and third-party institutional research.”) manages your assets based upon several model portfolios.  So far this sounds like you are getting a “prefab” portfolio managed by some unknown person(s).

For these services you will be charged a percentage of the assets that you have invested in the program:

Investment assets Percentage of assets fee
$100,000 or less 0.90%
$100,001 – $250,000 0.80%
$250,001 – $500,000 0.75%
$500,001 – $1 million 0.70%
Over $1 million 0.65%

 

These fees seem reasonable, but not cheap by any stretch of the imagination.  Remember there is no financial planning advice, just strictly portfolio management.

Note these fees do not include the expense ratios of the underlying investments.  The program description mentions that either an all mutual fund or all ETF portfolio will be used, it doesn’t sound like there is any mixing and matching of the two.  If I were a betting man I’d bet that all of the underlying investments are on some sort of E*Trade platform for which they pay for inclusion.

Unified Managed Accounts -$250,000 minimum

Complex financial needs require flexible investment solutions. Unified Managed Accounts offers broad diversification across several asset classes, tax management features, and access to experienced money managers—all in one professionally managed account. 

This option is actually managed by E*Trade advisors and an outside investment firm called Lockwood Advisors.  Investors in this service do receive more custom services such as tax-efficient investments and a portfolio that can include a combination of investment vehicles such as mutual funds, ETFs, and individual stocks.

The fees are of course a bit higher for these services, and frankly seem a bit on the high side to me:

Investment assets Percentage of assets fee
First $1 million ($250,000 minimum) 1.25%
Over $1 million up to $2 million 1.15%
Over $2 million to $5 million 1.10%
Over $5 million 0.95%

 

Again, note these fees do not include the expense ratios of the underlying investments nor does this include any sort of financial planning or wealth management services.

Questions to ask if considering E*Trade’s advice services  

  • Who exactly will be managing my money?
  • Who is my point of contact?
  • How much experience do these people have?
  • How much turnover has there been among the investment management and the Financial Consultant group?
  • Does E*Trade Financial receive compensation from the mutual fund and ETF providers they recommend?
  • What types of real (not back-tested) results has E*Trade achieved?

Note these are the types of questions that you should ask of any money manager.  And make no mistake you are hiring a money manager and not a financial advisor when you go with one of these services from E*Trade.  Note that mutual fund, ETF, and separate account managers are also considered money managers.

This is differs from a financial advisor who is also a financial planner and/or a wealth manager in addition to being an investment advisor.

Am I knocking E*Trade’s advice solutions, absolutely not.  What I am knocking is the lack of transparency and clarity in their commercials.  I would say to anyone considering these services that the ambiguity of these commercials is disturbing and this should be taken into consideration when evaluating their offerings.

Please feel free to contact me with your financial planning and investing questions.  

For you do-it-yourselfers, check out Morningstar.com to analyze your investments and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.

Photo credit:  Crunchbase

 

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