November 4, 2013

Why I’m Using Stock ETFs in Client Portfolios

About five years ago I conducted some research to determine if I could find ETFs to replace the mutual funds I was using. For example, I used every major subcategory and filtered the available ETFs through my Fiduciary Scorecard system. Then I took the best ETFs and compared them to my mutual funds. Because I used a strict quantitative process, the amount of bias was minimal. My conclusion? I found better choices for stocks and bonds with mutual funds, but ETFs were dominant in the alternative space. However, that was then, and this is now.

After a few years my paradigm has shifted. In short, I find many excellent choices among stock ETFs. There are a few reasons I prefer ETFs over mutual funds and in this post, I'd like to explain how I am using ETFs in portfolios with great success.

After 25 years in the business, I felt as though I had run the gamut. I had tried many different strategies and studied many more. Although academia can teach us a great deal about investing, until you test the theories in a real-world situation, it's still just a theory.

One important lesson I've learned is that too much diversification is not necessarily a good thing. In fact, it's only good in a bear market. A highly diversified portfolio will produce little fruit in a bull market. We'll get more into that another time. Back to the ETFs. 

Why I Like ETFs: Flexibility and TSOs

Most advisors who use ETFs do so for a host of reasons. One common reason I hear is that ETFs have lower fees than mutual funds. Whether this is true or not, it's wasn't part of my decision. There were two main reasons why I prefer ETFs. First, I like the intraday pricing. For instance, if you wake up one morning and find that futures are significantly negative, and the Asian markets are selling off in dramatic fashion, if you own stock mutual funds, you cannot liquidate until the end of the day. With an ETF, you can sell or buy at any time.

This proved beneficial back on Oct. 10 of this year. If you like to buy on the dips, as I do, the Dow bottomed on Oct. 8, had a very small gain the next day, and on the morning of the tenth, the futures were strong. I bought an ETF at the open, and was able capture two-thirds of the day's total gain. Therefore, flexibility is a primary driver.

Another key reason was the ability to add trailing stop orders (TSO). Briefly, placing a TSO under an ETF will provide protection in the event of a major stock collapse. You can't do that with a mutual fund. 

I'll have to leave it there for now, but will elaborate in a future post. 

Thanks for reading and have a great week!

 

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