More ETF Advantages - Diversification & Costs
By J.D. Steinhilber, Contributing Writer
In a previous article
we looked at the tax benefits of exchange-traded funds, as well as fund
swap strategies to harvest portfolio losses. This time we continue on
with more ETF advantages.
Diversification
Most advisors would agree that diversification is the single most important
investment priority. Effective diversification is most readily achieved
by combining poorly correlated asset classes in a portfolio. One
of the most basic examples of two poorly correlated asset classes is stocks
and bonds. Over time, the returns of these two asset classes have a very
low level of correlation. Over shorter time periods, the degree of correlation
between stocks and bonds can vary widely. From January 1999 to October
2002, for example, stocks and bonds had a negative, or inverse, correlation.
REITs and international stocks are examples of other asset classes that
tend to be poorly correlated with U.S. stocks.
Because exchange-traded funds replicate the performance of entire asset
classes, which themselves are diversified among numerous securities, it
is possible to construct well-diversified portfolios with only 5-10 ETFs.
Accordingly, ETFs provide a highly efficient means of diversification.
Mutual funds also facilitate diversification, but actively managed mutual
funds are susceptible to "style drift" and their portfolio holdings
at any particular time are unknown. This presents a challenge to diversification
efforts. In contrast, ETFs offer asset class purity, meaning their holdings
are totally transparent, disclosed daily and not subject to style drift.
Actively managed mutual funds are also more expensive and less tax-efficient
than ETFs.
Asset Class Investing
Asset allocation - how a portfolio is divided among various asset classes
- is the primary determinant of investment performance. Accordingly, one
of the most valuable services a financial advisor can provide is to complete
a personalized asset allocation model based on a detailed client questionnaire
and needs assessment. Asset allocation models are structured to produce
over time an expected rate of return and an expected variability of returns,
based on the assumption that long-range future returns will approximate
long-range historical returns.
Often depending on the complexity of the software or process used for
the client profiling/needs assessment, asset allocation models can range
from a simple stocks/bonds/cash allocation to a highly detailed suggested
portfolio encompassing a range of asset classes. In any case, ETFs are
elegantly simple tools with which to implement asset allocation models
because they greatly facilitate the security selection process. An advisor
simply matches the asset class in an allocation model with the ETF that
replicates that asset class, potentially eliminating the need for individual
stock, bond, mutual fund or money manager research and selection. Alternatively,
ETFs can be used for certain asset classes in the portfolio while other
asset classes are addressed with different solutions.
Cost Advantages of ETFs
Exchange-traded funds have some of the lowest expense ratios of any registered
investment product. As shown below, ETFs have a cost advantage, on average,
in excess of 100 basis points relative to actively managed mutual funds.
A 100 basis point (1.00%) cost advantage can have a significant
impact on a portfolio's performance over time. For example, assume that
investor A and investor B each invest $10,000 and earn the same gross
annualized return over a 20 year time frame. After expenses, assume that
investor A earns a net return of 10% and investor B earns a net return
of 9%. After 20 years, investor A would have $67,275, while investor B
would have $56,044, representing a difference of $11,231.
It is important to point out that investors have to pay commissions
when they buy or sell ETFs. As a result, the cost advantages of ETFs
relative to mutual funds diminish the more actively an ETF portfolio is
traded.
Investors tend to be more conscious of investment costs when portfolio
returns are low or negative. Given that costs are among the few controllable
variables in a portfolio's returns, investors and advisors should always
be evaluating portfolio costs relative to the benefits received. Exchange-traded
funds may provide an opportunity to enhance net returns by reducing investment
expenses.
12/05/2002
J.D. Steinhilber is the founder of AgileInvesting.com,
an investment advisory web site that recommends ETF-based portfolios.
