Why I use Index Exchange Traded Funds (ETFs). Let me count the ways.
- Simplicity: It saves the work of stock analysis.
- Increases probability of success: A literature search of index investing vs. active stock picking will have the honest researcher coming down on the side of index instruments. The literature is replete with this information as are the books on my Top Ten Book Recommendations. While individuals, through the efforts of picking stocks, will outperform the market over certain periods, there are very few individuals able do it over a 30- to 40-year periods. Such investors are known as outliers.
- Diversification: Instead of 15 to 20 stocks, a portfolio built on four (4) to six (6) ETFs will include hundreds of stocks. When this argument is made, stock pickers will counter – Why include many losers when one can be selective and pick winners? The answer to this question is that individuals have been shown time and time again they cannot consistently choose winners. Remember, good companies do not always make good stocks and bad companies frequently make good stocks. It is much easier to gain exposure to international markets (and other asset classes) through ETFs than it is to select international stocks.
- Portfolio Control: The longer I invest the more particular I am about risk control and it is much easier to control or protect a portfolio against a major draw-down if it is made up of a few ETFs. It is much easier, and less expensive, to sell one or two ETFs vs. selling 20 to 30 stocks.
- Low cost: While the cost of holding ETFs is not zero, if we use commission free ETFs we lower costs of portfolio management.
- ETFs vs. Index funds: ETFs are tax efficient and can be traded like stocks. These are two major advantages ETFs have over index funds. Avoid actively managed mutual funds as they are too expensive and generally have poor track records.
- Low Correlations: Diversification is not obtained by increasing the number of holdings, but rather by finding low correlated securities. This is easy to accomplish through correlation analysis. Many examples are provided on this blog.
The above list provides a compelling argument of why it makes sense to use non-managed index ETFs to construct a portfolio. If not convinced, do your own literature search and read all the books recommended on this blog. Then provide a counter argument, if possible.
Robert Ryan says
The argument for ETF/index portfolios is excellent except for the bond part of portfolio. As Bernstein points out bonds, especially corporate bonds are much less liquid than stocks within an “index” and if so mid-day sell is triggered, we are more likely to take a hit with ETF bond bid-ask price than trading at end of day with net asset value of a no load bond mutual fund. The expense ration of many Vanguard mutual is about the same as ETF without setting “limits” which seem closer to day trading than long term investing
Lowell Herr says
When it comes to ETFs in general, Bernstein is not what one would call a rabid fan. I have seen him soften his position over the years as each new book appears. I just reread his material on bonds in “Investor’s Manifesto” and I don’t think he would find too much to disagree with if one does not actively trade ETF bonds.
I use and recommend using limit orders so I have a better idea what hit I might be taking. One does need to keep in mind that the price of any ETF can walk away leaving one holding orders that will not be filled. This happened when Copernicus was launched as the limit orders were set too low just when the market started marching north.
For bond holdings, do you use bond funds, ETF bonds, or actual bonds themselves?
Robert Ryan says
Have a couple bond funds (include TIP) like Mwldx, then old term holding in tax exempt is bond mentioned by john templeton on $$WSW years ago. O% Canadian due 1214 so getting closer by has returned 6% + since purchase. Try and stay Away from bond taxable ETFs
Lowell Herr says
Can you provide some example tickers of taxable bond ETFs you would avoid?