When I first started Parkwood Capital in 2007, my coaching clients generally did not know what an Exchange Traded Fund (ETF) was, much less why it might be a better choice than a mutual fund. ETFs have now grown dramatically with over one trillion dollars invested. More and more investors are discovering the advantages of the ETF. Essentially, an ETF is a trust, consisting of a discrete group of stocks in fixed amounts and the investor is buying shares of that static fund. Immediately you see the principal advantage of the ETF - it isn't being actively managed and thus has much lower expenses than the average mutual fund.
Should I Own ETFs In My Portfolio?
The number one advantage of the ETF is its lower cost ratio. The average ETF will have a cost ratio of about 0.5%; many will be below 0.1%. By contrast, the typical mutual fund will have an expense ratio of about 1.5% and may have sales commissions on top of those fees. And those fees add up over time. Consider investing $10,000 into three funds:
- An ETF with a 0.5% expense ratio
- A mutual fund with a 1.5% expense ratio
- A mutual fund with a 1.5% expense ratio and a 3% sales commission
If we assume the underlying assets in each fund all grow at an annual rate of 8%, then at the end of ten years, the account balances of these three investments will be $20,610, $18,771, and $18,200, respectively. Those annual expenses add up over time!
Another significant advantage of owning an ETF is the ease and low cost of entering and exiting the ETF. ETF shares can be bought and sold exactly like stocks, and at the same low commissions. So you could buy into an ETF and then sell it the same day. You can't do that with a mutual fund, plus you will often find other restrictions placed on your exits from mutual funds.
The Advantages of Mutual Funds
The principal advantage of the ETF is also its liability: it is not actively managed, so it cannot beat the market by definition. If I buy the "SPYDRs", SPY, the performance of my investment will be identical to the S&P 500 Index.
The manager of the mutual fund is free to zig and zag with market shifts, although the prospectus of the fund will often place significant constraints on the manager, e.g., a maximum level for cash that can be held at any given time, a maximum investment in any one stock, and so on.
Very few mutual fund managers consistently beat the market averages. But if you believe you have found a super star, then the added expenses of her mutual fund may be a cheap price for the outstanding performance. But those super stars are a rare breed.
I personally use a blend of SPY (the S&P 500 Index) and QQQ (the NASDAQ 100) in my most conservative investment portfolio. But I always have a trailing stop entered on these positions, so I can automatically go to cash in the event of a crash. On occasion, I also sell call options against these ETFs (another advantage). In these volatile markets, my trailing stops often trip me out of these positions. But I can buy back in if desired for a very low trading commission; this is both flexibility and a cost advantage I don't have with mutual funds.
Meet Me In Las Vegas!
I have been invited to speak at the Forex and Options Expo in Las Vegas, September 13-15. My presentation will be web cast live from the Paris Hotel.
Why Aren't You Auto-Trading?
My Flying With The Condor™ service has now gained 40% to date in 2012. And this isn't a flash in the pan. We gained 39% in 2011 in spite of the August market crash. I know you're busy and auto-trading is the perfect solution. Whenever I send out an email alert for a trade or adjustment, the brokers at TradeMonster immediately enter that trade in your account. You still receive all email alerts and status reports, but you don't have to worry about missing my alerts or taking time to enter the trade. And Barrons rated my brokerage partner, TradeMonster.com, as the best brokerage for trading options.