So Many Choices

Today's investors face so many different investing instruments to choose from that it is often overwhelming. There are Mutual Funds, Exchange Traded Funds, Stocks, Bonds, Real Estate Investment Trusts, Annuities, Limited Partnerships, Options, Futures, Commodities, Hedge funds and more. To many investors, it is not worth spending the time trying to learn and understand all of the alternatives out there. That is why we pay Financial advisors/planners, brokers, consultants to help us navigate through the confusing world of personal finance and investing. I think that most of the instruments listed above can be useful for particular situations, but for most investors, a properly diversified portfolio of "plain vanilla" index funds is the way to go. Fortunately, there are fee-based Financial Advisors who carefully construct index fund portfolios for clients and charge low fees.

Below is a list of Financial Advisors who Offer Index Fund Advice:

Advisor Partners, LLC
Agile Investing
Appel Asset Management Corp
Blue Ocean Portfolios
Evanson Asset Management
Farm Creek Securities
Index Fund Advisors
Portfolio Solutions

ETF's versus Index Mutual Funds

Today, I'd like to compare and contrast ETF's and standard Index Mutual Funds. In order to do this objectively, one must investigate the following characteristics of each investment:

• Cost Efficiency
• Tax Efficiency

Cost Efficiency:

ETFs have a lower expense ratio (operating costs) than Index Mutual Funds. Therefore, they are cheaper to hold. However, investors pay commissions when buying shares of an ETF which is an additional expense that Index Mutual Funds don’t involve. Only when ETFs are bought in large sums with low price commissions and held for the long term (aka investing) are they more cost efficient than Index Mutual Funds. Unfortunately, many investors give in to their anxiety and/or greed and start trading ETFs like individual stocks, therefore depleting any returns that they could have achieved if they had bought and held.

Tax Efficiency:

ETFs win again in tax efficiency. ETFs are slightly more tax efficient than Index Mutual Funds. This is because of how they are created and redeemed. With ETFs, most of the capital gains are deferred until the date they are sold. This advantage is similar to the advantage that tax-deferred retirement accounts (401Ks & IRAs) offer. Don’t rule out Index Mutual Funds just yet, because they are still significantly more tax efficient than actively managed mutual funds.

Note: The degree of these advantages are subject to the investor’s marginal tax rate, how long the investment was held and the return on the investment.

Own Corporate America

Did you know that we can all own Corporate America? It's possible for a very low cost. With an index fund, that is what you are doing; owning a piece of Corporate America. John Bogle's new book, The Little Book of Common Sense Investing, has an interesting subtitle; "The Only Way to Guarantee Your Fair Share of Stock Market Returns." John Bogle explains why trying to beat the market is theoretically a zero-sum game. For every winner, there is a loser. He goes on to explain that "after the substantial costs of investing are deducted, it becomes a loser's game."
The only sure winner in the investing game (when trying to beat the market) is the middle man; the investment banker, the broker, the lawyer, the money manager, the marketer, the accountant and the "operational departments of our financial system." "Just like in the Powerball Lottery, the state always wins. This little book is packed full of compelling evidence supporting the many advantages of index funds.

John Bogle's Thesis Paper

John Bogle is the founder of The Vanguard Group in 1974. Vanguard is now the second largest mutual fund company in the United States. Bogle also wrote his senior thesis at Princeton University in 1951 titled; "Mutual Funds can make no claims to superiority over the Market Averages." John Bogle himself has proven that index funds are a superior investment long before he founded The Vanguard Group. Vanguard offered the very first index mutual fund available to individual investors. This index fund became known as the Vanguard 500 Index Fund.

Here are a few examples of index funds offered by Vanguard:

VBMFX - Vanguard Total Bond Market Index Fund
VTSMX - Vanguard Total Stock Market Index Fund
VGSIX - Vanguard REIT (Real Estate Investment Trust) Index Fund
VEIEX - Vanguard Emerging Markets Stock Index Fund
VEURX - Vanguard European Stock Index Fund
VPACX - Vanguard Pacific Stock Index Fund

Turnover Rates of ETFs

“Turnover Rate” is the percentage of the portfolio’s holdings that have changed over the span of one year. In other words; this number represents the level of trading activity. The turnover rate has an effect on all types of funds including ETFs. A higher turnover rate can lead to more trading costs and more capital gains distributed to shareholders (which they must pay taxes on). Turnover rates of ETFs are extremely low, because they are index funds and simply duplicate the index they are benchmarked to. Most of the turnover occurring within an index is due to mergers & acquisitions. The average turnover rate of an S&P 500 ETF is about 5%. On the other hand, an actively managed mutual fund has an average turnover rate of about 85%. Hmmm... makes you think doesn't it...

ETF Expense Ratios

Although all Exchange Traded Funds (ETF) are index funds, they still incur administrative / management / operating costs. All of these costs make up what we call the “expense ratio” of the Exchange Traded Fund (ETF). Unfortunately, “expense ratios” affect your rate of return. Let’s just say your ETF has an expense ratio of 0.50%. Therefore, if your ETF has a one year return of 10%, you don’t actually get to keep that 10 percent. After the ETF Company subtracts the 0.50% expense ratio, your return will be 9.50%.

Don’t be discouraged by this; ETFs have the lowest expense ratio of any type of fund. The average expense ratio of a U.S. Equity ETF is a mere 0.39%. The average for a Traditional Actively Managed U.S. Equity Fund is 1.48%. That is a huge difference, especially considering that index funds have outperformed 85% of all managed mutual funds over many years.

Just for your information, International ETFs have an average expense ratio of 0.68% (Traditional Actively Managed International Funds: 1.75%). Fixed Income ETFs have an average expense ratio of 0.17% (Traditional Actively Managed Taxable Fixed Income Fund: 1.13%). The cheapest ETF available is the iShares S&P 500 Index (IVV), which has an expense ratio of only 0.09%. On the other end of the spectrum; the most expensive ETF to my knowledge is the iShares Taiwan Index (EWT) with an expense ratio of about 1.03%. The Vanguard family of ETFs has the lowest average expense ratios at only 0.22%.

Conclusion:

ETFs are a significantly lower cost investment than Traditional Actively Managed Funds, not taking into account taxes and brokerage commissions.

STOCK PICKING IS A LOSING STRATEGY

Here is a great article about stock picking and indexing that I have recently found (click on the link to read entire article):

Title of Article: Is Stock Picking Declining Around the WorldThis article argues that there is a move towards indexing. This article is objective and credible.

Some interesting data from "Is Stock Picking Declining Around the World"

• "There is more stock picking in emerging markets than in developed countries"
• Despite the above observation, stock picking is declining everywhere.
  
• Stock picking in U.S. has gone from 60% in the 1960s to 24% in the 2000s.
• The author concluded (based on a theoetical model) that stock picking will eventually settle at 11% of trading volume in the U.S.
  

Young and looking to invest...well, time is on your side

One thing I noticed in High School and College was the lack of financial education. Many fellow business students at my college didn't have a clue about investing. Those that claimed they were stock market experts, thought they had "crystal ball" predicting abilities which as we all know; spells disaster. Index Mutual Funds and Exchange Traded Funds are a great way for young people to start investing, especially considering their (often) lack of financial education and inexperience. If you are young, time is on your side, start today, and the power of compounding and diversification of index funds will astound you. Be a savvy investor; minimize your risk and maximize your reward.

First Fundamentally Weighted ETFs

Most Exchange Traded Funds (ETFs) are benchmarked to market cap-weighted indexes. In fact, most of my portfolio is comprised of these. Recently, a company called WisdomTree became the first family of Fundamentally weighted funds. The weights of each holding in these funds are not just determined by the market-cap of the company, but instead the fundamental values of each security. It will be interesting to see if the performance of these ETFs can negate the efficient-market theory

Predictability of Index Funds

A third advantage of index funds over active funds is their predictability. I am not talking about being able to predict with a glassball what the market is going to do next year. However, I can predict with great accuracy that an S&P 500 index fund will match the performace of the S&P 500 index. In addition, I can predict fairly well what stocks the S&P 500 index fund will hold next year. The reason I say fairly well is because the index changes very little each year, often due to mergers and acquisitions, which I cannot predict. Mutual Fund managers are sometimes known to change their investment style over time. In other words, your Large-Cap Growth mutual fund may slowly become a Mid-Cap/Large-Cap/Growth/Value mutual fund with or without you knowing ahead of time. This is called "Style Drift." Managers of index funds do not practice "Style Drift." That is why they are predictable.

Cost Efficiency of Index Funds

Actively Managed Funds have a professional fund manager making all the calls on trades. The investors pay the manager's salary through a percentage of the invested assets each year. This percentage is called the expense ratio. The expense ratio is made up of management and administrative costs.

The expense ratio differs dramatically between actively managed funds and index funds. For instance, the average expense ratio for actively managed funds is about 1.5%, while the average expense ratio for index funds is approximately 0.25%. That means investors in actively managed funds are paying on average 6 times more in expenses than they are for index funds. That is a high price to pay considering index funds outperform 85% of actively managed funds over many years.

These expenses eat away a large chunk of investors’ money over long periods of time. This especially hurts the investor when the expense ratio doesn't correlate with the performance of the fund.

To help fully comprehend the consequences of investing in high cost mutual funds, here is an example of how much it would cost to hold versus a low cost index fund.

Lets assume both funds earned average annual returns of 11% (11% is the average annual return of the S&P 500 index over the past 30 years) per year for 20 years with an initial investment of $10,000. Assuming the actively managed fund had an expense ratio of 1.5% (active fund average); the holding cost over the 20 year period would have been $21,032. Therefore, after 20 years your investment would be equal to $59,591.

On the other hand, assuming the index fund had an expense ratio of 0.25% (index fund average); the holding cost would have been only $3,937. Therefore, after 20 years your investment would be equal to $76,686.

Now that is a huge difference! In addition, factor in the tax efficiency and the long term superior performance of index funds and you've got a NO BRAINER!!

Tax Efficiency of Index Funds...instant return

Long-term; a properly diversified portfolio of index funds will deliver a superior return than conventional actively managed mutual funds. There are several reasons for this, some more important than others. Today, I’ll talk about the first major factor, which is the tax efficiency of index funds. By their nature, they have a very low turnover rate, which means that index funds distribute very little capital gains (which is taxed) to shareholders. For instance, there are many index funds that are benchmarked to the S&P 500 index, which only had a turnover rate of about 6 percent per year over the last 10 years according to the S&P 500 Directory. Most of this very low turnover was triggered by mergers and acquisitions. Most actively managed mutual funds fail to meet or beat their respective benchmark index funds on a pre-tax basis. On an after tax basis, the index funds beat the actively managed funds by an even wider margin. When we look at the turnover rate of some of Vanguard’s actively managed Large Cap mutual funds, we see turnover rates between 7% and 357% in any given year. However, I must emphasize that the average turnover rate for active funds in general is significantly higher than that of index funds.