The Big Question #27: Why We Prefer ETFs

Hello and welcome to this month's edition of The Big Question. The investment world comes with no shortage of investment options. As technology and tools develop, this only continues to expand, becoming more complex, more overwhelming, and frankly at times more confusing. All of this leads me to this month's big question: Why ETFs? As in, why do we at Presilium use exchange-traded funds, or ETFs, as they are known, as opposed to all the other investment vehicles available to us? This is such a great question, and there are a number of different ways to take this, but to keep this relatively concise, I'll distill it down to three key reasons: the cost, the flexibility, and the performance.

In a world where the cost of trading continues to go down, this is less related to trading costs and more related to the internal expenses of different investment vehicles. For most of the highly traded, popular, and liquid ETFs, the expense ratio continues to work its way closer and closer to zero. Now, for many people, this, along with the additional reasons I plan to highlight shortly, is reason enough to utilize ETFs, and a large reason they have exploded in popularity over the last 15 to 20 years.

There is, however, still something that we see time and time again when we are introduced to new prospective clients. We see a portfolio cluttered with mutual funds that often have expense ratios ranging from half a percent to 1% or more. Now, what's worse, there are often also mutual funds that have underperformed their benchmark, but we'll come back to that later. The reason for this increased cost is the management team and the ongoing expenses associated with their work and their goal of outperforming the benchmark. Instead of just buying the index, these teams are actively buying and selling, incurring additional management costs, capital gains, and so forth.

We have a few issues with this, but one of the larger ones from our perspective is outsourcing the investment management. From our perspective, we don't want to outsource this. Our investment strategy, our investment philosophy, is such a core piece of who we are and a core piece of how we achieve the goals derived from our clients' financial plans. We don't want to outsource something as critical as this to a third party. We construct our own portfolios. We rebalance our own portfolios. We make our own investment decisions. If there are adjustments in the construction and composition of our portfolio, we are the ones making them. That is, in our opinion, our job and part of our service offering.

Secondly, the flexibility, or agility, offered by ETFs, especially during volatile markets, is so crucial to us and another reason that they're our preferred investment vehicle. ETFs, like individual stocks, trade intraday. This means that if we place a buy or sell order at 10 a.m., we get the price at 10 a.m. Mutual funds, on the other hand, get the price at market close, 4 p.m. While this may be okay on most days, during days of volatility, it's usually not.

For example, we recently had the opportunity to rebalance our clients' accounts twice in one day. In the morning, the market opened down significantly and we bought right away, capitalizing on the significantly discounted prices. In the afternoon, however, the market had not just fully recovered, but soared 5% from where it had bottomed out earlier in the day, leading us to rebalance our clients again, this time selling at the now more expensive prices. If we had owned mutual funds, it would have been impossible to do any of this. Furthermore, if using mutual funds and we had placed buy orders in the morning, by the time the market had closed later that afternoon, those attractive-looking buys would have occurred at the afternoon's significantly higher prices, totally defeating the purpose of making those purchases at a discount.

And lastly, performance. And I don't mean performance as in ETFs outperform anything and everything else. I mean performance in the sense that we understand and know how our ETFs are likely to perform over time. If we want to track a benchmark, we simply buy the ETF that corresponds with that benchmark and therefore own that benchmark in its entirety, making the understanding of how it's likely to perform far more simple. How that differs from a mutual fund, for example, is that a mutual fund's manager will generally aim to outperform a benchmark, leading to those higher internal costs we discussed earlier. Sometimes they do better, but seemingly more often they do worse.

For example, over the last 10 years, over 84% of large-cap managers, those tracking the S&P 500, underperformed the index. Now, if we extend that to 15 years, that number becomes even worse, increasing to just under 90%. Pretty significant underperformance. So, it's our opinion that instead of paying more for something that may have an 85 to 90% chance to underperform the benchmark, we'd rather just go out and buy the benchmark and know what we're going to get. And as it relates to individual stocks, God bless anyone who can do that consistently. I've not yet met them, nor heard of them, nor do I know how they'd be able to manage and track hundreds of individual stocks across their many client portfolios while doing any sort of meaningful financial planning. And if, as some of our favorite data states, 90% of a portfolio's return variability can be explained by asset allocation, and asset allocation derived from the goals developed within the financial plan, I think I know where I'd prefer to spend most of our time and focus. Thanks for joining me everyone. Until next month.