ETFs are popular and getting more popular by the day and there are many reasons for this. But there are also quite a few drawbacks with ETFs. But before we get too deep, let’s review a few items.
First on the list to review is the difference between active and passive investing. This lays at the heart of the ETF “raison d’ etre”. Let’s take a look.
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 more expensive than many ETFs 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.
Is that all you need to know?
Is cost enough to throw out actively managed funds and stick with ETFs and other passively managed funds? I don’t think so.
There are also the issues of performance and risk.
Passive investing can expose investors to great risks. That’s because passive investors buy and hold and must be 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.) If you are OK with all that, passive funds are the way to go and ETFs probably are a good fit. All you have to do is buy the right ETFs.
What about active investors?
For active investors, the story is quite different. ETFs might be a good fit. But active funds might be good too. Remember, active investors have different goals than passive investors – and this is the key. They are usually very concerned about both performance and risk.
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.)
Asset allocation is one example of active investing. You shake up your portfolio by selling and buying at certain intervals. But there are other tools at the disposal of active investors. You can also use market timing strategies to some extent or the other. Timing means you buy certain funds at certain times and you sell them at other times based on some predetermined performance 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 it doesn’t have to be if you use a well-reasoned approach.
Why It’s OK For Active Investors To Use ETFs And Actively Managed Funds
Regardless of how you behave as an active investor, if you make investment decisions based on the performance, it just doesn’t matter if you use ETFs or actively managed funds. If the performance of the actively managed fund is far better than the ETFs’ performance in the short term, you buy the more expensive actively managed fund. If the ETF is doing better, that’s what you buy. Performance numbers always net out expenses anyway.
This explains why I use actively managed funds and ETFs. I am agnostic when it comes to investments. I just want the best performers in my portfolios.
The bottom line is: using actively managed funds and ETFs is consistent with my goals, which are to use a systematic approach to reduce risk.
Do actively managed funds have a place in your portfolio? Do you only go with ETFs? Why or why not?
Kirk,
Your points are spot on. I don’t believe you can use active funds and walk away. If you use active funds you need:
a. some mechanism that will help you find those performing better than 80% (at least) of the others
b. a method that re-examines your holdings every so often. I do it monthly.
I look at short-term performance (a year, 9 months, 6 months, 3 months and rank the universe of funds that are in a similar risk category. I then select the top performers. Then, I re-run the process monthly.
This is still no guarantee that it will outperform buy and hold – I admit it.
Again, it’s a question of what you want out of your investing and what you are willing to accept from it as well.
Neal,
Solid post, but I am not sure that active funds are topping most index based vehicles right now. In fact, the number over 2008 and 2009 from what I have seen has been 90% fail to top the index.
And, it isn’t the same 10% or 20% that beat the market each year so it is very difficult to find the top managers. Bill Miller is a great example. So how do you pick the right managers? This is just as difficult as picking the right stocks.
MJ,
Thanks. Yes…you bring up a great point and one that did not occur to me. Lots of blogs offer personal experience and there really is a place for that. But I think readers can gain in a different way by having an objective view point – even if they disagree.
Thanks Pal.
Neal,
Great Post. I think there is a more important you indirectly bring up (please tell me if I am wrong).
Comparing this post with the other 3,000 posts out there on investing from blogs like your’s and mine – highlights the difference between professionals (you!) and those that want to control their own investments (most other blogs).
Both have their place, but there is a reason you get paid by clients to invest and it has nothing to do with your’s and the financial industries’ jedi mind tricks.
Great post buddy!
Ray,
Good points. I would never suggest that anyone use an active strategy with loaded funds.
To your point about the fleeting nature of market gains – again you are right. Active funds will likely get slammed more as the market pulls back. Also, as I tried to point out, probably not strongly enough, an active strategy could – and will – under perform for extended periods of time. If you look at the post on timing (linked) you’ll see an example of a strategy that goes back decades. While there were long periods of under performance, overall the strategy did an excellent job.
Interesting post Neal, however I don’t think I am still convinced of purchasing Mutual Funds over ETFs. When you purchase Mutual funds you will either pay a hefty upfront commission fee (3-6%) or be on a DSC for 6 years or longer, plus over time you are paying hefty MER’s around 2.3%. Some funds maybe beating the index now that we have had a little rally, but when there is a pull back these funds get hit harder than the index, there is no real way of knowing which fund will beat others in advance only in hindsight do we know this. with ETFs we know that if we have a diversified portfolio and a proper asset allocation we will at least perform as good as our benchmark.