ETFs:
The Easiest, Most Hands-Off Way to Invest

January 24th, 2009

It’s easy to get overwhelmed when you’re new to investing. The alphabet soup of acronyms and industry jargon are suited to professional investors, but not the layperson. I’d like to focus on one closeted little acronym that goes a long way: ETF. Exchange Traded Funds are brilliant and often overlooked tools. For the armchair long-term investor there are few better choices.

A Primer

When someone says the value of the stock market has gone up or down, they’re talking about the overall movement of thousands of companies altogether. Some companies will increase in value, some decrease, but as a whole how does the stock market typically perform? Pretty good it turns out.

For decades investors measured their success against the market as a whole. The best of the best could sometimes outperform the market, but usually not for long. With the computerization of investing in the late 90s, investors were suddenly able to buy investments that mimic the market precisely. There became no reason to gamble on an investment advisor who could beat the market; you could buy the market itself!

These investments that mimic the market are ETFs. Usually they are split into segments of the overall market (financial, resources, big companies, small companies, et cetera), and they are generally kept hush-hush as financial advisors get lower commissions from selling them.

Benefits

The most common market investments are individual stocks and mutual funds, which are groups of stocks managed by a professional. ETFs offer many advantages over these. Comparatively, ETFs are:

Simple: With endless lists of mutual funds and stocks to choose from, ETF choices are refreshingly few. Simply pick the type of market you’d like to invest in: energy stocks, for example, or a market as a whole for less volatile returns. Furthermore, mutual funds often impose complex restrictions you must spent time researching (example: fund xyz cannot be redeemed within seven years unless paying an annually declining penalty). With ETFs you will see none of these types of limitations.

Hands-off: For the long-term investor, buying into an ETF is a good strategy. Since entire markets tend to recover faster and more reliably than individual stocks. This allows you to ride out recessions knowing your investment will rebound effectively and enjoy boom times knowing you’re earning your fair share. There’s no labouriously researching individual mutual funds and stocks to see what their prospects are, you’re investing at a much higher level.

Proven: During the 1990s the S&P 500 Index (comprised of the 500 largest companies in the USA) returned 17.3% annually. The average diversified mutual fund returned 13.9%, whilst charging greater fees to their investors [source].

For his undergraduate thesis at Princeton, John C. Bogle [founder of Vanguard, an investment firm with approximately 1.3 trillion in managed assets] conducted a study in which he found around three quarters of mutual funds did not earn any more money than if they invested in the largest 500 companies simultaneously, using the S&P 500 stock market index as a benchmark. In other words, three out of four of the managers could not pick better specific “winners” than someone passively holding a basket of the 500 largest public U.S. companies. [source]

Inexpensive: Since exchange traded funds are traded like stocks, you pay the same fee you would if purchasing an individual stock. When cost is compared to mutual funds, ETFs are typically the clear winner: mutual funds often charge fees to buy/sell meanwhile skimming management fees off your returns that are far higher than with ETFs.

Novices and Pros

If you’ve been thinking of getting into the markets there’s no time like the present. Putting a portion of your savings into a proven investment vehicle like an ETF is a good choice for both novices and even seasoned investment professionals. ETFs industry-rattling nature and low commission payments have made them one of those hidden industry “secrets” everyone hunts for, so consider opening up a self-directed investment account and trying one out.