5 C
New York

Passive investing beats active investing, ETFs beat mutual funds

Published:

Most fund managers never match the performance of the broader stock market indices. So why spending time selecting the right stock market fund and paying expensive management fees when selecting a couple of low-cost exchange-traded funds does the job much better?

History of ETFs

Since coming onto the investment scene in 1993, the market for ETFs has expanded dramatically, bringing the total number of exchange-traded products to more than 2,000. This rapid growth has given investors more options than ever before, expanding the universe of investable assets to include nearly every geographic region, asset class, and investment strategy imaginable.

But this growth has also complicated matters for some investors. Sometimes picking the best ETF from an already shortened list can be a daunting task if you don’t know where to look. Below are five important statistics and descriptive metrics to consider before purchasing an ETF.

Expense Ratio

Why it’s Important: ETFs have gained so much ground on mutual funds in part because of their low-cost structure. While mutual funds on average charge between 1.5 % and 5 % in annual fees, some ETFs charge as little as 0.00% annually.

ETFs are generally cheaper, but there is a surprising amount of deviation between various funds. Within the Emerging Markets ETFdb Category, for example, expense ratios range from 0.14% to 0.98%, a gap wide enough to drive a truck through. Once you’ve narrowed the universe of ETFs down to a few different options, be sure to compare the fee structures between funds. A difference of a few basis points doesn’t seem like much, but it can add up very quickly over the long term.

How to Find it: You can check websites such ETFdb which have focused on ETFs. Each ETFdb Ticker Page includes the expense ratio for each fund. It may also be useful to compare the expense ratio of an ETF to the average for its ETFdb Category.

Index Methodology

Why it’s Important: When indexes were used primarily as benchmarks against which manager performance was measured, few investors gave much thought to the rules governing their construction and maintenance. But now that ETFs have transformed indexes into (effectively) investable assets, investors have begun taking a much closer look at index methodology.

Most of the indexes to which U.S.-listed equity ETFs are linked use a market capitalization-weighting strategy, meaning that the allocation given to a particular component stock is based on the market cap of the company. But ETFs utilizing “alternative” weighting methodologies have become increasingly popular in recent years. Some investors prefer equal-weighted funds that address some of the inherent flaws in cap-weighting, while others have found weighting systems based on revenue, earnings, dividends, and fundamental measures of size to be potentially superior (see this Guide To ETF Index Weightings).

How to Find it: A description of the underlying index is almost always available from the issuer’s home page. Generally, the description of the index on the issuer home page will include details on the weighting methodology used to develop the benchmark.

Depth of Holdings

Why it’s Important: Once upon a time, mutual funds burst on to the investment scene in part because they make it possible for relatively small investors to gain access to a large, well-diversified pool of assets. ETFs present a very similar value add in this area, allowing investors to gain exposure to a basket of securities with the purchase of a single share.

But the depth of exposure offered by otherwise similar ETFs can be very different. For example, the FTSE/Xinhua China 25 Index Fund (FXI A-) has 54 individual holdings, while the SPDR S&P China ETF (GXC A) has about 356. More isn’t necessarily better – it’s sometimes advantageous to concentrate holdings in a small group of securities – but the depth of exposure offered can have a significant impact on an ETF’s risk/return profile.

How to Find it: Almost every ETF issuer prominently displays the number of securities underlying an ETF on the ticker home page. If you can’t find it there, this figure can be computed from the daily holdings data required of each ETF.

Tracking Error

Why it’s Important: Nearly every ETF description includes something along the lines of “ABC seeks to replicate the performance of the XYZ Index,” indicating the benchmark to which fund returns can be expected to correspond. Many investors assume that all ETFs match the underlying index exactly, but this isn’t always the case. Unlike a hypothetical index, for which the rebalancing process is the flip of a switch, ETFs must actually go out into the market to buy and sell securities at certain points. Moreover, the depth of certain indexes (some have more than 8,000 individual components) makes exact replication difficult, and forces certain funds to use a sampling process.

Tracking error is a good measure of the efficiency of the ETF manager. The smaller the difference between an ETF and its underlying index, the better.

How to Find it: Somewhere on the fund homepage, the ETF issuer will provide performance data for both the ETF and the related benchmark, generally for the most recent quarter and year, as well as three-, five-, and ten-year periods (if the data is available). It’s also worth noting that iShares offers a pretty slick tool that allows investors to view tracking error over customized time periods (see the tool in action here).

Tax Efficiency

Why it’s Important: Another big draw of ETFs is the potential for advantageous tax treatment relative to actively managed mutual funds. Because of the nuances of the creation/redemption process, as well as the inherently lower turnover, ETFs can be “more tax efficient” than mutual funds (and in fact, most are). A good way to measure this tax efficiency is by examining the distribution history for the fund.

Ideally, ETFs will make zero short-term capital gains distributions since the presence of these outflows indicates that short-term gains (which are taxed at higher rates) were incurred by the fund managers. Ordinary income distributions are just fine (these are generally unavoidable and taxed at a more investor-friendly rate), but a regular history of capital gains distributions can be a red flag.

How to Find it: The distribution history of most ETFs can be found on the issuer web site. In most cases, distributions will be classified as either ordinary income, short-term capital gains, long-term capital gains, or return of capital.

Passive investing via index funds beats active management by fund managers in the long run. Image Source: Imago Images

A list of quality ETFs

1. SPDR S&P 500 ETF (ticker: SPY)

This iconic fund is one of the easiest and most cost-effective ways to tap into the U.S. stock market. Benchmarked to the 500 largest publicly traded U.S. corporations that make up the S&P 500, this ETF rounds up top names from all corners of the American economy including tech like Apple (AAPL), banks like JPMorgan Chase & Co. (JPM) and health care companies like Johnson & Johnson (JNJ). The fund has nearly $300 billion in total assets and shows a trading history that dates back to 1993.

iShares Russell 1000 Growth ETF (IWF)

If you want a little more upside potential in your investment strategy, an easy step is to bias your portfolio toward stocks that are seeing faster-growing profits and sales than their peers instead of simply moving with the herd. That’s what IWF tries to provide, by taking a list of the 1,000 largest U.S. stocks and then screening out the bottom half using quantitative metrics such as measuring earnings growth rates. As a result, the IWF portfolio has about one-third of its total assets in technology stocks and nothing in utility companies. This strategy has paid off, as IWF rose by about 8% in the first half of 2020, while the broader S&P 500 index was slightly in the red. But watch out: Volatility of the fund is usually higher than the underlying index.

Vanguard Value ETF (VTV)

What worked before may not work in the future. And while growth stocks outperformed in early 2020, some investors are looking more toward value investments as technology companies may look a bit overheated and economic uncertainty has settled in. Think stocks with a strong credit rating, lots of assets to back up their operations and long-term relationships with customers. VTV, then, has a very different makeup from the prior IWF growth fund. Tech stocks represent just 8% or so of the portfolio, with big financial firms like Bank of America Corp. (BAC) and health care companies like insurer UnitedHealth Group (UNH) representing much of the portfolio.

Schwab U.S. Dividend Equity ETF (SCHD)

The natural next step for many investors looking for stable value investments is to seek firms that have a commitment to sharing their steady cash flow with investors over the long term. That’s what this Schwab dividend fund does, with an average yield of about 3.5% across its portfolio of roughly 100 top U.S. stocks. The fund is full of stable names you’ll recognize, like chipmaker Texas Instruments (TXN) and delivery giant United Parcel Service (UPS). But SCHD has picked these companies based on their payout potential and not just their size, meaning investors can tap into an above-average income strategy while focusing on America’s top corporations. So the story goes.

iShares Edge MSCI Minimum Volatility USA ETF (USMV)

Though it may appear the most complicated fund on this list, USMV is fairly straightforward when you take its long name one step at a time. This ETF is benchmarked to an MSCI index of low-volatility U.S. stocks – meaning it seeks out stocks that may rise a bit slower when the market is soaring but decline a lot less in times of trouble. This idea appeals to low-risk investors in 2020 who may be concerned about another big move like the crash we saw for stocks in March. With holdings like Verizon Communications (VZ) and garbage giant Waste Management (WM), the fund’s focus on some less glamorous but more stable companies may help protect investors in bear market times.

Vanguard FTSE Developed Markets ETF (VEA)

So far, this list has focused on U.S. equities. If you want to add some geographic diversification to your portfolio, then consider this VEA fund that looks only at major developed markets like Europe and Japan to build its portfolio. Though foreign companies, you’ll surely recognize top holdings like Swiss consumer giant Nestle (NSRGY) or Korean electronics firm Samsung Electronics (SSNLF). This Vanguard fund makes it easy to gain a foothold overseas with a portfolio of roughly 3,900 different stocks.

Vanguard FTSE Emerging Markets ETF (VWO)

For investors who are a bit more adventurous, this sister fund from Vanguard offers a focus on emerging markets like China, India, Brazil, Russia and Mexico. These markets come with a bit more risk, particularly when it comes to virus-related economic impacts. But they also have brighter long-term growth potential thanks to consumer and technology trends. Top holdings in this fund are Asian tech powerhouse Alibaba Group Holding (BABA) and Russian energy giant Gazprom (OGZPY). This broad Vanguard fund offers access to more than 5,000 emerging-market stocks in just one holding.

iShares Core U.S. Aggregate Bond ETF (AGG)

Thus far, all the ETFs on this list have covered stocks. However, bonds are an important part of any portfolio – particularly for investors uncertain about going all-in on stocks right now. That’s what makes AGG one of the best ETFs for 2020. This diversified bond fund covers all corners of the bond market, including corporate bonds and government bonds of all stripes. The only requirement is that these bonds qualify for the higher investment-grade ranking, meaning a low likelihood of default. With rock-bottom fees, a low risk profile and a wide-ranging portfolio, AGG is a one-stop shop for bond exposure.

iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)

This fund cuts out government debt to focus only on investment-grade corporate bonds. LQD omits low-risk, low-yield government debts in favor of high-quality corporate loans to the likes of Goldman Sachs (GS), CVS Health Corp. (CVS) and AT&T (T). While these companies aren’t quite as secure as the U.S. government, it’s a pretty sure thing they will be around in the next few years to pay off their debts and drive performance of the LQD bond fund. And in exchange for that minor increase in risk, investors get a yield of more than 3% in this ETF, based on the last 12 months of distribution payouts.

SPDR Gold Shares (GLD)

Given the uncertainty to start the year, some investors are still interested in safe-haven investments in 2020. That’s what GLD offers with an exchange-traded investment that consists entirely of gold bullion whose performance is benchmarked to the precious metal. There are drawbacks to investing in gold, since this commodity can be volatile and doesn’t play by the same rules as the stock market because it has no profits or revenue to speak of. However, gold is a fundamentally uncorrelated asset, which means it has the ability to move separately of the stock market. Case in point: Gold rose 15% in the first half of the year as many stocks stumbled, proving it may be a safe place to stash cash for the rest of 2020.

Conclusion: Attractive ETFs to select from

  • SPDR S&P 500 ETF (SPY)
  • iShares Russell 1000 Growth ETF (IWF)
  • Vanguard Value ETF (VTV)
  • Schwab U.S. Dividend Equity ETF (SCHD)
  • iShares Edge MSCI Minimum Volatility USA ETF (USMV)
  • Vanguard FTSE Developed Markets ETF (VEA)
  • Vanguard FTSE Emerging Markets ETF (VWO)
  • iShares Core U.S. Aggregate Bond ETF (AGG)
  • iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
  • SPDR Gold Shares (GLD)

Related articles

spot_img

Recent articles

spot_img