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Using Exchange-Traded Funds: How to Put Your Index Mutual Fund on Steroids
by Dr. Scott Brown, Advisory Panelist
Tuesday, March 10, 2009: Issue #952
It seems we’ve been talking about bottoms and whether we reached it yet for quite some time. But this talk will shift soon to the “now what” questions of what to buy when we do reach that magical point.
Many will shun individual stocks for the safety of mutual funds. And with the explosion of index funds, we’ve never had a larger variety of options to help us diversify. These index funds are designed to yield a return equal to that of a particular index. They allow you to purchase a variety of assets as a low-cost, passive-investment strategy. And there are a number of indexes that specify sectors, stock indexes and international markets.
It’s a powerful strategy that allows you to slice and dice the global economy in a risk-managed approach. But we don’t like to stop simply at reducing risk and diversification.
There’s another cousin to the mutual fund and index fund families that many investors have heard of but haven’t taken advantage of. If you own mutual funds, indexed or otherwise, you need to know if using exchange-traded funds (ETFs) makes more sense for you. Here’s what you need to know about ETFs, the close relative to your mutual funds…
Exchange-Traded Funds – Index Mutual Funds on Steroids
Exchange-traded funds (ETFs) were first introduced in 1993, and are based on index mutual funds. They use similar principles, but have fewer management and transaction costs associated with them.
Unlike mutual funds, which can be bought or sold only at the end of the day when NAV is calculated, you can trade ETFs throughout the day, just like a share of stock.
- Exchange-Traded Funds are a portfolio of shares that can be bought or sold as a single unit.
- You own a proportionate amount of the shares held, with some ETFs even allowing transfers-in-kind.
- They can range from portfolios that track broad global market indexes all the way down to very narrow industry indexes.
- Exchange-Traded Funds are becoming a preferred way for investors to get all of a mutual fund’s benefits, with none of the downsides.
Think of ETFs as mutual funds on steroids.
Exchange-Traded Funds Becoming More Popular
While exchange-traded funds are becoming more popular by the day, they weren’t always so highly regarded. In fact, the creator of The Vanguard 500 Index Fund was against them and vigorously attacked the possibility of their success. In the end, John Bogle ended up adding a whole series of ETFs to the Vanguard family.
ETF investments quickly competed against indexed mutual funds. By early 2007, over $400 billion was invested in over 300 ETFs in three general classes:
- Broad U.S. market indexes,
- Narrow industry or “sector” portfolios,
- And international indexes.
The first ETF, like the first indexed mutual fund, matched the S&P 500 index and was given the symbol SPDR for Standard and Poor’s Depository Receipt. Many know it by its nickname, the “spider.”
Spiders spawned many new exchange-traded fund products like “Diamonds” that are based on the Dow Jones Industrial Index DJIA, Qubes based on the Nasdaq 100 index, and WEBS based on the World Equity Benchmark Shares of a portfolio or foreign stock market indexes.
The Advantages of Exchange-Traded Funds Over Indexed Funds
A big advantage of an exchange-traded funds over a conventional index fund is that they trade continuously throughout the day. You can buy and sell ETF shares just like a share of stock, while with an indexed mutual fund – where the net asset value is quoted – you have to place an order to buy or sell but that doesn’t transact until after the market.
This can be frustrating if your technical analysis indicates a buy or sell trigger at some point during a trading session but the market moves too far for you to take advantage of it by the end of the trading day.
And unlike mutual funds, exchange traded funds can be sold short or purchased on margin like a share of stock.
When you analyze these factors in light of the fact that options also trade on exchange-traded funds you can place positions in the general market, global market, or industry sectors, where you can:
- Employ protective hedges with puts or calls on your long or short ETF portfolio.
- Use combined buy-write options strategies where you collect premium from the short sell of an option to compensate for the cost the long options – bull and bear spreads, calendar spreads, diagonal spreads, butterflies, iron condors and so on, are all available to you trading ETFs but NOT with indexed mutual funds.
Exchange-traded funds also have tax advantages over mutual funds:
- When large numbers of mutual fund investors redeeming their shares – but you don’t – the fund has to sell securities to meet the redemptions. This creates a capital gains tax that is passed on to the remaining shareholders.
- Which means you end up paying the other guy’s tax obligation!
- In an exchange-traded fund, when somebody else sells, they have to pay the tax, not you.
- And when very large trades redeem their positions in the ETF, the transactions is settled with shares of stock in the underlying portfolio – not triggering a stock sale by the fund sponsor and no bogus tax bill to you.
It all starts with education,
Dr. Brown
Today’s Investment U Crib Sheet
We discussed John Templeton in yesterday’s black board based off the number of S&P 500 stocks trading at or under a dollar a share. Years ago, Mark Skousen showed us 5 steps Templeton used to become as successful as he did, in Sir John Templeton’s 5-Step Strategy For Financial Success. We’ve excerpted the first three below…
- Strategy # 1: Take Calculated Risks. John Templeton started off by taking significant risks in his business and investments. In 1939, he borrowed $10,000 from his boss to bet on 100 stocks listed on the NYSE selling for under a buck. A high percentage of these companies were close to bankruptcy, but Templeton reasoned that they would recover during a wartime economy. (It pays to have a correct “macro” view of the world.) In four years, he sold all the stocks, paid off the debt, and pocketed $40,000 in profit.
- Strategy # 2: Save, Don’t Spend. Templeton started out poor, but through the principles of thrift and hard work, he was able to get ahead. When he married, he and his wife set a goal of saving 50% of their income. He avoided consumer debt – in fact, Templeton bought his first home with cash. He carried his “cheap” approach into later life.
- Strategy # 3: Shop for Value Investments. Templeton follows the fundamental “bargain-hunting” approach to investing. “The long-range view requires patience.” His Templeton Growth Fund, which he ran for 50 years before turning it over to the Franklin Group, held stocks for an average six to seven years. He always searched for companies around the world that offered low prices and an excellent long-term outlook. “It’s not easy,” he states, “but if you’re going to buy the best bargains, look in more than one industry, and look in more than one nation.”
Under Templeton’s managing skills, the Templeton Growth Fund averaged a 14% annualized return over 50 years, far outperforming the stock market indexes.
- Exchange Traded Funds: 4 Ideas For Income Investors
- Another Reason to Avoid Mutual Funds
- Dollar Cost Averaging
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6 Responses to “Using Exchange-Traded Funds: How to Put Your Index Mutual Fund on Steroids”
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Dr. Brown specializes in teaching stock investing because as he emphasizes "the stock market is where individuals and families have the best shot at succeeding financially!"
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March 10th, 2009 at 7:48 pm
I found it interesting that you favor ETF’s over mutual funds, while on the same page is Alex Greens book that promotes nothing but Indexed mutual funds.
My understanding is that mutual funds are generally held for longer periods of time, and therefore the tax issues shouldn’t be a consideration. If using Vanguard, you make the purchase directly and avoid broker fees and have the lowest management fees in the industry.
Where am I going wrong with this thought process?
Reply
Alexander Wissel Reply:
March 11th, 2009 at 8:52 am
You’re absolutely correct in your questioning and we can understand you confusion. In a general comparison, we prefer ETFs hands down over mutual funds for the reasons listed above. However, ETFs haven’t reached the breadth of numbers or performance history we require for our investment choices. In those cases we will always err on the side of caution when recommending investment options.
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Dr. Scott Brown Reply:
March 16th, 2009 at 8:46 pm
The tax issue comes from index mutual funds you purchase directly and pass on the capital gains tax bill to you when others sell out while you sit patiently over the long haul in a set it and forget it strategy. ETFs do not have this tax problem.
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March 11th, 2009 at 12:37 am
Double and triple leveraged ETF’s are causing the wild volitility on the upside and the down side.
If you were around in 1987 you know what portfolio insurance did to the markets.
Reply
Dr. Scott Brown Reply:
March 16th, 2009 at 8:42 pm
There is a tight relationship here between the underlying index, the indexed mutual fund, and the exchange traded fund (ETF) where the index fund and ETF both derive their pricing from the underlying index — NOT the other way around. If there was an opportunity to move the underlying index you would have large investment banks speculating in the index fund (called positive feedback trading). Professor Goetzmann and Massino from Yale and Insead, find no evidence of positive feedback trading in index funds in their 2003 Journal of Business article entitled Index Funds and Stock Market Growth. Josh Cherry, University of Michigan at Ann Arbor, in his 2004 article The Limits of Arbitrage: Evidence from Exchange Traded Funds shows that ETFs are about 17% more volatile than the underlying index. So, it’s actually the other way around. Speculation in the ETF creates volatility in the ETF NOT the underlying index. So, it’s not the ETF inducing the volatility in the index — remember that the number of shares the ETF holds is set from the start — it’s the less liquid nature of the capital market, commodity, or segment thereof that the index is tracking that moves around. Small cap companies and especially those that have share prices under $10 have significantly higher volatility than the reverse. My point is that small, obscure indexes underlying an ETF or indexed fund should be watched with greater caution — greater volatility is simply to be expected from the nature of the underlying market itself.
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March 16th, 2009 at 7:58 pm
The key consideration in deciding between ETFs and Indexed Funds is the size of the individual’s investment. If an investor dollar cost averages $100 a month into a standard or Roth IRA with a $7 commission there will be a $70 reduction in account value from the start for the 10 allocations in the Gone Fishin Portfolio —70% of the $100 investment eaten up in commissions hurts! Indexed funds, on the other hand, can be purchased directly — circumventing the brokerage commission. But, if an investor puts the annual maximum into the account in one shot each year — $5,000 for 2009 — then that same $70 is only 1.4% of the total investment — and in this case the investor can reap the enhanced advantages of owning ETFs; daily trading, options, no bogus tax bills, etc.
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