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:

And the No. 1 Stock-Fund Manager Is…  The Wall Street Journal
What is a mutual fund?  Economic Times

Trade Stocks for Real

I read a comment by a forum member on another... Read More

Analysts - Do They Really Know The Stock Market?

When you become interested in a stock or mutual fund... Read More

Expense Ratios

Mutual funds and brokers are always preaching not to buy... Read More

Economists #2

Economists know more about how the fragments of society work... Read More

Trading For A Living - Part 1

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

Time Out

Are you paying any attention to your retirement savings? Do... Read More

A Triple Dipper: How to Make 3 Profits on 1 Stock Trade

This is a rather simple strategy with which I am... Read More

Never Lose Money

Never lose money in the stock market again. Yeah, I... Read More

Emotional Involvement

I'll bet with almost anyone that has stocks or mutual... Read More

Buying Mutual Funds

It looks like the market is ready to start up... Read More

How Much Information Do You Need?

You have decided to buy some stock or mutual funds,... Read More

Stealth Bull

If you have been watching the stock market at all... Read More

The Seven Mistakes All Novice Traders Make and How to Correct Them

We learnt the following the hard way! If any of... Read More

Evaluation II

As I said in Part I everyone in the insane... Read More

Struggling Stocks, Booming Commodities

04/28/2005NASDAQ dropped -12.5% year to date in 2005. S&P500 index... Read More

Stock Valuation using the SMP Model

Disclaimer: Please note that I do not necessarily purchase, own,... Read More

How Much Money Can I Make With Trading? What Account Size Do I Need To Start?

What account size do I need?How much money can I... Read More

Choosing A Fund

For years I have been saying you must have a... Read More

Seecrets on Investment: Tired of Making Huge Losses in the Stock Market ? Part 2

Fundamental analysis.Fundamentals analysis says the best way to predict the... Read More

Forces that Move Stock Prices

Among the largest forces that affect stock prices are inflation,... Read More

Different Types of Mutual Funds

This is a guide to the different types of mutual... Read More

Prospering with Mutual Funds: How Anyone can ?Afford? an Investment Advisor

Recently I was invited to appear on a live CNNfn... Read More

Trading Stocks ?Never Forget About A Past Trade

We all know that emotions control every decision that an... Read More

Humpty Dumpty the Stock Market Falls Down

Humpty Dumpty had a great fall and all the King's... Read More

The Information Age

It is wonderful to be alive in the information age.... Read More