DIY Portfolio Management

Exchange Traded Funds (ETFs) are growing. Investors are choosing low annual expense and market return over high annual expense and promised performance.

Total ETF inflow is growing faster than Mutual Fund inflow. ETF inflow grew from $42.5 billion in 2000 to $54.4 billion in 2004. In contrast, mutual fund inflow fell from $309.4 billion in 2000 to $180.3 billion in 2004. Standard & Poors Depositary Receipts Trust (SPY) is the largest and oldest ETF. From the one fund SPY started in 1993 the number of ETFs has grown to 150 in 2004.

Growth of ETFs is fueled by investors searching for market performance. About 20% of conventional mutual funds do beat the market. The puzzle is which funds will win, in the future. ETFs, on the other hand, have a reasonably good record of matching the performance of their underlying index. For instance, in 2004, SPY value grew 10.92% and the value of the underlying S&P 500 index grew at 10.88%. The promise of the conventional mutual fund is that it will deliver superior results. The promise of the ETF is that it will match the performance of its underlying index.

Expense for ETFs is less than for conventional mutual funds. A prime reason for the mutual funds' higher expense is that pros perceived capable of superior results are more expensive than technicians paid to duplicate the holdings of an index. ETFs are passive investments and don't require the active management of pros. Investors moving money from mutual funds to ETFs are trading promised performance and high expense for market returns and low annual expense. ETFs generally have expense ratios below 1. SPY's expense ratio is .12. Expense ratio is percent of assets consumed by fees annually.

Investors sticking with mutual funds have a couple of things going for them. Eliot Spitzer has used his New York State Office of Attorney General to scare/shame mutual funds into minding fiduciary duties to their investors. The growth of ETFs is pressuring mutual funds to reduce their expenses and to introduce ETFs mimicking mutual funds. Investors sticking with mutual funds might benefit from the growth of ETFs. However, mutual funds might have a hard time delivering. Slowing growth or actual decline in fund size will make it difficult to reduce their expenses enough to keep investors happy. The more investors defect the fewer left to share the expense.

ETFs trade like stock equities. They can be bought and sold whenever the market is open. They can be shorted, purchased on margin, and optioned. Most brokers charge a commission for every buy and sell transaction. This can be a problem for small investors building a portfolio with monthly contributions. There is at least one broker that charges an annual fee rather than per trade commissions.

ETFs are passive. They only trade when changes are made to the composition of the underlying index. Fewer trades mean less tax consequence. Mutual funds often have taxable capital gains, sometimes even in years when the fund has declined in value (sell winners and hold losers).

That 20% of mutual funds beat the market is a premise. It assumes multiply years and a market defined as the S&P 500. Meg Richards writing for The Associated Press reported that for 2004:

- The S&P500 bested 61.6% of actively managed large-cap funds.

- The S&P400 bested 61.8% of actively managed mid-cap funds.

- The S&P600 bested 85% of actively managed small-cap funds.

The probability of a mutual fund having beaten the market in 2004 is low. Of course, relative performance changes from year to year. Relative performance, of active versus passive management, changes. Relative performance, of individual actively managed funds, changes.

The best ETFs strategy for small, beginning, busy investors is to 'buy and hold' SPY. If you are bigger, experienced, or have time on your hands you can try a more active strategy. A strategy that beat the S&P500 over the last three years is to hold equal amounts of five large diversified ETFs and rebalance weekly. This strategy is in some ways just an expansion of our definition of 'the market' beyond the S&P500. This strategy since inception 3 years ago has beaten the S&P500 just over 1% annualized. This small gain means rebalancing weekly is only viable when it is without trading cost. A more aggressive strategy is to monitor 50 ETFs and hold the most oversold, rebalancing weekly. This strategy since inception 2/27/04 has beat the S&P500 by 16%.

Remember. ETFs' popularity is on the rise. They trade like stocks. They have lower annual expense than mutual funds. Their objective is to mimic the performance of an index. They don't beat or lose to the market, they are the market. It is usually best for low maintenance, 'buy and hold' investors to define the market as broadly as possible.

Lyle Wilkinson, investor, trader, author, MBA Helps individuals learn to self direct their stock portfolios. Book, e-book, PowerPoint "DIY Portfolio Management" http://www.diyportfoliomanagement.com [email protected]

In The News:

The 25 Best Mutual Funds of All Time  Kiplinger's Personal Finance
How the Stock Market Works | Investing 101  U.S. News & World Report
How to Invest in Preferred Stock ETFs  U.S. News & World Report

Trading For A Living - Part 1

There can't be many traders who haven't at least considered... Read More

The Next Bull Market

We are already in it, but you can't see it.... Read More

Boiler Room 7/17/00

On Friday or Saturday evening my wife gets a movie... Read More

What Our Investment Advisor Wont Say Off The Bat

Most advisors will tell you they can beat the market.... Read More

Gold Fever

Right now there doesn't seem to be any "gold fever".... Read More

Hedge Funds

You read and hear a lot about hedge funds. Unfortunately,... Read More

More Window Dressing

Two weeks ago I wrote about what the Securities and... Read More

?Fears Only Enemy Is Action?

What a great statement!I just heard someone use it in... Read More

Small-Cap Stocks: The Beginning of the Journey

When an individual investor wants to roll up his sleeves... Read More

Discover the Retirement Breakthrough the Federal Government Created for You - The Roth IRA!

If you don't know what a Roth IRA is then... Read More

Trading Systems

To become a successful trader you must have some kind... Read More

Choosing An Investment Stock Broker

If you want one.And I don't recommend any broker with... Read More

Hill of Hope

Just about now everyone is confused as to which way... Read More

Inverted Interest Rates

Inverted interest rates? What's that? Who cares? Even if you... Read More

The Elephant

Four blind men were asked to give a description of... Read More

What is a Trading Plan ? and Why You Need One?

How do you make money without picking tops and bottoms?I... Read More

Choosing a Stock Broker

If you were to find that you had some severe... Read More

Trading Tips No 6: The High Cost of Low Cost Stock Market Information

It has been said that low cost or even free... Read More

Performance Funds

Mutual funds are doing more and more to discourage investors... Read More

Dividends

When is a dividend not a dividend?The latest thing "conservative"... Read More

Is Active Trading The Answer?

One of the main reasons many of us get into... Read More

The Stock Market - Part 1: Believe It Or Not, Its Always Been Your Best Friend And Always Will Be

Regardless of the fact that the world's stock markets have... Read More

Dont Buy Worldcom! A Guide to Wise Bottom Fishing

Over the past few months, several investment professionals have brought... Read More

The 401(K): How The Insider Has Stolen Your Retirement!

Mutual funds were moderately successful in creating a presence in... Read More

Fools Gold

The stock market has been in an up trend for... Read More