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.