Exchange-traded funds, or ETFs, are a popular and effective investment product utilized by many individual and institutional investors. Generally speaking, an ETF fund models the performance of a particular market or market sector index; when you invest in an ETF, your money grows or diminishes according to the performance of the index as a whole. ETFs run the gamut from mild to wild. For example, you can invest in ETFs which model a broad U.S. stock market such as the S&P 500 or the DJIA; you can also find ETFs which model foreign stock markets, like emerging market stocks. There are also indices which mirror other markets such as commodities, real estate, bonds or currency. ETFs provide a easy way to diversify at low cost with greater tax efficiency than you would find in the traditional mutual fund. This is why ETFs a popular choice for many DIY investors.
Because you are investing in a basket of securities and not individual securities ETFs are considered a passively managed investment. This approach differs from the traditional actively managed fund in the sense that the securities in a mutual fund are actively managed throwing off taxable activity. Passively-managed funds are essentially binary: you are either “all in” or “all out.”
The portfolios we build for our clients often include ETFs for cost savings and diversification. Our experience has shown that ETFs are an excellent choice for portfolios built for “the long run,” and that they complement our actively-managed funds nicely. (Our investment strategy is generally “active.”)
If you’re considering making ETFs a part of your DIY investment strategy, we strongly recommend that you avoid tying up too much of your portfolio in passive investments. There are literally thousands of ETFs available, and the “point and click” ease with which you can buy into them makes it easy to overweight a portfolio with passivity. Incorporating some passive investments in a generally active portfolio is a solid strategy for most DIYers. Leave yourself some room to move pieces of your portfolio around if you need to, without the pressure of being “all in” on passive investments.
Having said that, we’re not advocates of “timing the market” or being impulsively active; we believe that the truest course to financial security is a long-term one. But we review our clients’ portfolios regularly and actively make adjustments based on their goals and tolerance for risk. Including ETFs in the portfolio mix gives us the flexibility to make adaptations with both the short term and the long haul in mind while still preserving the focus on diverse, low-cost investments. This is an approach to asset allocation that works well for us, and translates equally well for most individual or DIY portfolios. It’s a good long-term strategy; recent research from Morningstar indicates that on average, active funds outperform passive funds in market downturns, and passive funds outperform active funds when the markets are on the upswing. Funding a diverse portfolio never goes out of style.