Don’t Buy ETF Investments Before Reading This

Folks talk about the difference between active and passive investing all the time, and when the subject comes up, so do ETF investments. It comes up when folks ask how to invest $5,000 and it comes up when they ask about investing $5 million.

But when deciding between active or passive investing, people almost always miss the one issue that is all-important. I’ll go into this issue in detail, but before I do, I need to give you a few disclaimers:

1. I am a financial adviser but this series is NOT meant to be a commercial for my services or any particular strategy.  I’m just trying to explain the pros and cons of different investments and investment strategies. I’ve written other posts that discuss the best retirement investments.  This is educational only.

2. This stuff is dry.  If you are a regular reader, you know I always try to spice it up a little.  Try as I might, I just couldn’t find anything entertaining about mutual funds or ETFs. Forgive me. But I think this information is important, so I’m taking the chance and presenting it anyway. Please grab a cup of coffee before you start or stick your feet in ice water while you read.  You decide.

Let’s get to work.

On Tuesday, I outlined the difference between active versus passive investing. Let’s review.

Actively managed mutual funds are an example of an active investment because the manager of the fund actively buys and sells stocks and/or bonds. Actively managed funds are relatively expensive because of the high price the fund pays for managers and research departments (among other items). Of course these funds are never too shy to pass these costs on to you.

ETFs and index funds are passive investments because these funds do very little buying and selling. They are also very inexpensive (often costing less than 1/5 the cost of an actively managed fund) because, for the most part, they buy and hold securities. They don’t need to pay for high-priced fund managers and research departments.

Should you buy passive or active funds? I don’t know yet (and you may not have all the information you need to make a decision either.) Before you can make an informed decision, there is just a bit more background information we have to explore together.

We must understand the difference between being a passive and active investor. This is the all-important issue that most people ignore. A passive investor is one who manages her portfolio…well…passively.  You could be a passive (or active) investor regardless of whether you want to retire now or 30 years from now.

She buys and holds her funds. She doesn’t want to worry about what to buy, when to buy or when to sell.  She doesn’t want to take the risk of underperforming the market. She’s willing to accept whatever the market dishes out. (If you are a passive investor, you must be willing to take whatever the market brings your way.)

Since, as I said on Tuesday, 80% of the actively managed mutual funds perform worse than their respective indexes, a passive investor would be very attracted to ETFs and that would be a smart decision. That decision would basically guarantee that the investor will beat 80% of the actively managed funds. Booyah!

Can passive investors buy actively managed funds? Sure, but it’s usually a mistake. Why? As I said, 80% of the actively managed funds fail to perform as well as the indexes. Are there active funds that beat the indexes year in, year out?

Well, I can’t say what will be in the future, but there certainly have been a few funds that consistently beat the market. However, those are hard to find and the past really is no guarantee of future results. Managers change. Even if they don’t, everyone has a bad year (or two…or three). No matter how smart you are, if your goal is to get as close to market returns as possible (good and bad), ETFs are indeed a very good alternative.

What about active investors?

For active investors, the story is quite different. Active investors have different goals than passive investors – and this is the key.

Active investors aren’t willing to take whatever the market dishes out.

They either want to beat the market when it’s good or they want to beat it when it’s bad by losing less than the market. (If you want to do both, I have bad news. Can’t be done.)

You could use an asset allocation plan to try to achieve either of these two goals. But another way is to be an active investor. Think of this as a choice between using antibiotics or surgery.  The active approach is more aggressive than the asset allocation approach. Nobody can guarantee either will have a better result in any particular case.

Let’s take a look at two approaches used by active investors:

1. You might try to beat the market by using market timing strategies.

(Oh, I said it: the “T” word. Since it’s not really a four-letter word, stay with me.)

Timing means you buy certain funds at certain times and you sell them at other times based on some predetermined strategy – not based on your gut feeling or what your cousin Tim told you last week at a birthday party. Timing can be a dangerous way to invest  – but not always. The reason why this doesn’t work for most people is because:

a. They don’t use a system.
b. They expect it to work all the time.

Market timing uses short-term tactics (buying and selling) to achieve long-term goals.

It’s not realistic to have short-term expectations when you use market timing, but people do it all the time. As a result, they lose money, get disappointed and go on the next idea.

2. Another tactic that you might use to beat the market might be to try to only invest in funds that are in the top 20%. Again, you have to use a system to do this, and they system you use will not be perfect so please – expect imperfection.

Regardless of how you behave as an active investor, since you are making investment decisions based on short-term performance, it just doesn’t matter if you use ETFs or actively managed funds.

If the performance of the actively managed funds is far better than the ETFs’ performance in the short term, you buy the more expensive actively managed funds. Performance numbers always net out expenses anyway.

This explains why I use actively managed funds right now. They are beating the pants off of comparable ETFs and index funds. When ETFs start beating the comparable funds, I’ll gladly use them again.

We’ve covered a lot of ground. Let me emphasize a few points:

a. Just because you use an active strategy doesn’t mean you should buy and sell whenever you feel like it.

I recommend using a strategy. If you don’t have a strategy, you should indeed stick with buy and hold, and in that case ETF’s are the way to go.

b. No strategy is perfect.

I spoke about the success rules of investment strategies in an earlier post. One of the rules can be summarized by saying that nothing is perfect. If you decide to use a given strategy you have to accept that you will be disappointed – sometimes in a big way and sometimes for a long and painful time. If you decide to use a (well-researched) strategy, you have to do so because you have long-term goals. Like buy and hold, even great active strategies don’t work all the time.

Another important point to keep in mind is that all active investors have to accept the risk that they may not achieve their goals in any one year – or any number of years. So, for example, if you are an active investor and you want to protect yourself in the bad years while growing your money safely, you may not always achieve that. You may do worse than the market does in a bad year. That would be disappointing of course, but it is a possibility.

If you want to beat the market (by either doing better in the good years or by not doing as badly in the bad years) you might use actively managed funds. You would do this only when the returns of such a strategy (over the long term) do better than buy and hold even after the increased costs of using actively managed funds.

In order to do that, you have to have a strategy.

OK. Guess what…it’s very late again and I really need some sleep. This post has gone much further than I had originally anticipated. I don’t know if you have questions/comments about this or if I’ve confused you even more.

The bottom line is: using actively managed funds is a tool I use because it’s consistent with my goals, which are to use a systematic approach to reduce risk.

Have I convinced you that actively managed funds might have a place in your portfolio if you have similar goals?