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ETF Portfolios – The Stock Investment Case for Exchange-Traded Funds

When most people start investing, they listen to the most common investment advice. These are the solid but rather simple points you hear repeatedly such as the need to diversify your holdings.

While this is a great suggestion, it can lead new investors astray

What ends up happening is they first buy stocks from companies they know and trust. As they get more comfortable they branch out, research companies and acquire more stocks. They have heard that diversification is key so they continue adding. They now have a broad portfolio of both value and growth stocks.

Before long, they have forgotten why they chose these companies and are struggling to maintain such as large portfolio. The benefits of diversification seem outweighed by the complications of an ever-expanding portfolio.

After all, the threat of bankruptcy or dwindling profits is always a concern. Stocks need to be monitored long-term. With today’s disruptive technology entire industries can change quickly.

ETF based portfolios provide many advantages that don’t fall victim to this spiral of complexity that traditional stock portfolios tend to have. Let’s take a closer look.

Combine the ease of stocks with the diversification of mutual funds.

It’s really easy to buy stocks today and that’s in large part thanks to brokers that trade commission free.

But the world wasn’t always this way. At one point not a single broker was free and every purchase in the market incurred a fee. The ability to buy less than 1 full share, called fractional shares, was also unheard of. Now there are many brokers where you can do this.

We’re in the age of the retail investor. Anyone with a smartphone can trade stocks without fees, buying as little at a time as necessary. Even $1 trades aren’t off limits. The Gamestop saga has illustrated how powerful it is to have stocks so readily available to the average person.

ETFs are easy to trade and highly liquid

An ETF is an exchanged-traded fund which means it is bought and sold on exchanges just like stocks. Nearly every broker provides equal access to stocks and ETFs. These funds can be highly liquid with billions of dollars in AUM.

Buys or sells must be placed throughout the trading day and investors will own a share of the ETF’s basket of underlying assets.

Diversification

When you own shares of an ETF, diversification and simplicity are greatly enhanced.

ETFs are comparable to mutual funds where you can invest in many different assets such as stocks, bonds or commodities by simply owning the fund.

An exchange-traded fund can represent several assets but they most commonly are a basket of stocks. When you invest in an ETF you own shares of that basket. If the underlying stocks in the basket go up, so do your shares.

One common misconception is that ETFs are for beginners or those who don’t know what they are doing. Let’s explore the benefits of an exchange-traded fund to see if this is true.

ETFs can be just as profitable as individual stocks.

Many people feel as if ETFs are a safe and diversified way to invest and therefore not as profitable. While this may be true for small-cap investors chasing the next big win, it’s not true for the majority of investors.

Most long-term investors are choosing mid to large cap stocks from relatively well known brands. This also happens to be what a lot ETFs consist of, although there are plenty of small-cap growth funds as well.

So how can an ETF be as profitable as a portfolio of individual stock selections?

The majority of investors can’t beat the market.

Past data shows that even the professionals can’t generate a return for their clients that exceeds the performance of benchmarks such as the S&P 500 – an un-targeted index which tracks the biggest companies in the U.S.

This includes hedge funds and investment firms that devote all their time and energy to finding the right stocks.

As you can see, over a 15 year period, the benchmark outperforms the vast majority of funds. The chart includes all types of funds with targeting by market capitalization and growth/value, it represents the challenge of picking good investments.

Given this data, it is amazing that so many new investors start by selecting their own stocks. The odds suggest that most investors would be better off putting their money in indexes and other passively managed funds.

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

Warren Buffett, Chairman, Berkshire Hathaway

This is not to say that buying stocks you have picked yourself is always a bad move. Sometimes you know a winner when you see one. However, it should at least make you consider some of the other options.

Many ETFs can provide better returns than your own stock selections. There are funds on all fronts of investing with some as safe as buying these popular benchmark indexes and others that aggressively target their picks.

Passively and actively managed options.

ETFs can be passive or actively managed. Given the challenge to beating the market, you might think passively managed funds are your best option but there are benefits to both.

Passively Managed ETFs

Some ETFs are as simple as passively tracking existing indexes. Examples include SPY, IVV, and VOO.

These are funds that track benchmarks with the examples above tracking the S&P 500. They have very low expense ratio, meaning they hardly charge you a fee for using them.

If you invest in one of these examples you would net an almost identical return to the S&P 500 index. Chances are, this will outperform most funds that attempt to beat the S&P 500 index with a similar investment approach.

Many people use ETFs for this purpose. It allows them to invest in the indexes outside of their 401k or IRA in a taxable account at their brokerage. They are fantastic for this purpose – here is a list of the many thousands of them available.

Actively Managed ETFs

On the other end of the spectrum are actively managed ETFs.

These are funds with active management behind them that buy and sell the underlying assets in the basket as they deem fit. As previously covered, you do have to exercise caution when it comes to these types of funds. Anytime you are trusting a person or team to select stocks for you, there is a chance it will under-perform.

With that said, actively managed funds can be a great asset in a portfolio. They present great opportunities to leverage your wealth in ways that will provide a greater return.

When you are confident a specific sector or type of stock will do well, they can help you target your investments without having to spend days researching.

These funds are typically invested in for 1-5 years or longer. If it is a sectored ETF, you may want to consider selling once the sector has reached its peak performance. From the benchmark chart you can see that some funds outperform their benchmarks over short-term periods such as 1 or 3 years.

For many investors, it’s easier to trust their team of researchers than to trust your own stock expertise.

Keep in mind, actively managed ETFs do have higher fees. However, they generally fall between 0.20% – 0.80% making them affordable and better priced than mutual funds.

Let’s dig into targeting a bit further and explore why it matters.

Target sectors, market caps, regions, dividends and more.

The greatest aspect of ETFs is their flexibility. There are funds for everything including those with highly specific targeting.

Sector Targeting

If your belief in a sector such as clean energy, genomics or any other has strengthened and you know the industry will do well, an ETF is a great way to gain exposure.

Exchange-traded funds allow you to buy a basket of those stocks without having to do any research. Instead, the team behind the ETF is in charge of actively managing the fund. They choose what to buy and sell and when to do it. As an investor, you benefit from their effort by owning the fund.

This allows you to make informed and educated decisions that have potential to beat the market but without getting too risky. When you hand select each stock, you are in charge of managing those picks long-term. This is true even if you selected the stocks based on the recommendations of another source. ETFs incur less risk and are safer ways to buy into sectors.

Market Cap Targeting

Similar to targeting specific sectors, you can also target by market capitalization of the underlying assets.

  • If you’re seeking maximum growth with accepted risk, low cap growth ETFs are a good option.
  • If you’re seeking budget stocks that are a clear deal, you might opt for mid cap value ETFs.

Whatever your strategy is, there is sure to be an exchange-traded fund that can bring it to life.

Keep in mind, with low-cap ETFs the assets will be sold once they approach maturity. That means had a superstar like Apple been in the mix during its early days, it would have eventually been dropped from the fund once it was no longer a small cap. However, these funds are still viable because that early growth period is often when the largest onset of gains occurs.

Regional Markets

ETFs are also a great way to target specific markets. International funds that exclude the United States can be quite popular, just as funds that only include U.S. securities are rather common.

There is a broad range of ETFs for targeting regional markets:

  • Emerging market funds
  • International funds
  • China, India, Asia-Pacific, etc.

Dividends

Is yield a priority in your portfolio? For many investors, it is. Myself included.

Generating yield allows you to earn compounding interest by reinvesting the dividends. This is a great way to passively grow an investment portfolio. Each quarter your assets will generate a dividend payment that will post to your cash balance where it can be allocated to further investments. If you’re with M1Finance, they have a feature to auto invest the dividends into your own targeted portfolio setup with pie-chart percentages.

As your portfolio matures you can consider using your dividend payments as income which can be very beneficial to retirees.

Better hedging with commodities and other ETFs.

During a currency crisis, hedging against the dollar and other currencies can be very valuable. Many investors were rewarded handsomely for doing so during the great recession.

Precious Metals

ETFs can track commodities directly such as a gold or silver fund that corresponds to the price of the physical metal. Some trusts even store the physical metal for you with redemption available at anytime.

ETFs can also hedge against the dollar by investing in securities related to precious metals. For instance, gold and silver mining ETFs are very popular funds. When physical metal prices spike, the miners typically do very well.

Rare and Demanded Metals

There are many other possible hedges to consider beyond the precious metals. This includes lesser traded metals such as copper or uranium.

Copper is used for electrical equipment and many expect nuclear energy to revive the uranium market. These are metals which have secondary factors to their price, much like silver but differing significantly from gold.

Traditional Commodities

There are also traditional commodities such as oil, coffee, natural gas, wheat, corn, cotton, sugar, etc. There are several ETFs that provide broad exposure to such a diversified group of commodities.

Cryptocurrencies Coming Soon

Bitcoin and possibly other cryptocurrency ETFs are speculated to be coming soon to ETFs near you.

If nothing more, a strong portfolio benchmark.

I’m by no means advocating that your entire portfolio should be ETFs. While a significant portion of my own investments are composed of ETFs, I do believe that selecting individual stocks can be worthwhile.

The best advice I can give is to use ETFs as a personal benchmark in your portfolio.

For instance, if you’re looking at the clean energy sector and considering a few individual stocks, why not add a clean energy ETF to your portfolio as well?

This allows you to compare the performance of your stocks to your chosen ETF long-term.

It should become pretty apparent whether your stock decisions have outweighed the performance of a safer and more diversified approach with ETFs.

I recommend investors do something similar with passively managed ETFs that track indexes. Investing a small percentage of your portfolio in a few standard indexes is a great way to compare your long-term performance with the S&P 500, Nasdaq, Russell 2000 and others. If your investment choices are consistently under performing the market, this way you know immediately and can make corrections.

A quick note on what broker to use.

For the type of portfolio I am advocating for there is no better broker than M1Finance.

Managing your money becomes dead simple:

M1 specifically caters to long-term investors and they have a large amount of exchange-traded funds to select from.

The software and interface can be intimidating at first but its pie-like structure makes for some of the easiest automated investing for a well managed portfolio. With percentage based allocations and automatic re-balancing, once you have mastered their system you will never want to put your money anywhere else.

That is of course unless you have fallen down the rabbit hole of investing in cryptocurencies, something we are increasingly bullish on and advise all investors to consider with a small allocation and build confidence from there.

One of the greatest perks of M1Finance is their margin loans that can be used for anything. Paying for school, a wedding or a new car? You can do all of that with a lower interest rate than just about any other broker. This is a great tool for long-term investors that don’t use margin or leveraged trading. Rather, a collateralized loan service can be useful for beating the banks.

I hope you considered this ETF analysis useful and will find practical ways to incorporate funds into your portfolio.

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