ETF: A Whole New World

08/06/2004 12:00 am EST

Focus:

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

"For the past 27 years we have strived to give you the tools, resources, and advice to reach your financial dreams," notes Doug Fabian. "In 1977 we introduced no-load funds. Now, we think investors should consider adding exchange-traded funds to their strategy."

"Al l is not well in mutual fund land. High fees, weak performance, and restrictive trading practices are cause for all investors to reconsider every mutual fund they own. Let’s start with the fees. Mutual funds are full of them: management fees, 12b-1 fees, transaction costs, taxes, sales and surrender charges. When compared to an exchange-traded fund (ETF), mutual funds are just too darn expensive. Some funds are charging as much as 2.5% annually and that fee comes with a surrender charge should you decide to sell. The average fund’s management fee is 1.4%, compared to an ETF, which can be as low as 0.10%, which is a difference of 1300%.

"Mutual fund management fees have grown way too high. Next we have the issue of performance. Now that we have experienced a real bear market the argument that superior fund management was worth the cost has gone out the window. Many stock mutual funds have not beaten a money fund over the past five years. The main reason? Fees. Sure stocks went down, but what we have to remember is that the fund companies got paid every month even if they lost your money. Active money management, which is what you pay for within a mutual fund, will outperform indices in a bull market; but in a decade where we have a bull then a bear several times over, indices will better serve our purposes. Index investing is what you get with ETFs, as each ETF choice is based on a specific index.

"Importantly, there is an aggressive campaign being waged by the fund industry to lock you into buying and holding all mutual funds. They want your money to stay put no matter what they charge you or how it performs. Last year’s mutual fund scandal involving short-term trading has been a windfall for funds to tighten up trading rules. Now most mutual funds carry some sort of redemption fee. Many international funds carry fees as high as 2%. Compared to ETFs, where you have no trading restrictions and instant order execution, ETFs win hands down. Also, remember that mutual funds are priced just once a day. With ETFs you can liquidate your assets within minutes. In my opinion ETFs demand your attention and assets. I know change is difficult for many people, but we must change with the times. I am not suggesting any changes within your 401k. Mutual funds work fine there, but when you have a choice, buy ETFs through your brokerage account and you will find a whole new world is opening up to us.

"What ETFs do we recommend? We have selected five ETFs that investors should consider using as part of their portfolio allocation:

S&P 500/BARRA Value (IVE ASE)
Russell 2000 Value
(IWN ASE)
S&P 500 Index Shares
(IVV ASE)
S&P MidCap 400 (MDY ASE)
S&P 500 (SPY ASE).

"I’d note that the Dow Diamonds (DIA ASE) didn’t make the final list of ETF recommendations for two very minor reasons: one, because we wanted to provide a shorter, more concise list of options and, two, because the Dow is comprised of just 30 companies and, therefore, isn’t as diversified as the S&P 500. If you want to buy the DIA because you like the fact that it’s a very prominently displayed index and that makes its price movement easy to follow, then by all means, you have my blessings to make it a part of your portfolio.

"We are trend-followers here at Successful Investing . When there is a clear upward or downward trend in the market, our strategy works well. This historically happens about 80% of the time. But the other 20% of the time, the market trends sideways and stays in a trading range—a trend-follower’s biggest challenge. So, what may appear to be a solid advance can quickly lose steam. We last flashed a buy signal on June 7. And while I’m excited about the buy, I remain cautiously optimistic. Why? We didn’t experience a selling climax prior to the buy; summer is the least active trading season of the year; presidential election years are typically volatile; and there are upteen geopolitical factors, including the Summer Olympics in Greece, that add elements of uncertainty over the market. Since we are at risk of a whipsaw because of the lack of momentum and current trading range, one way to manage risk is by fund selection and allocation and the use of ETFs can save on trading fees should we experience a whipsaw."

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