An Exchange Traded Fund (ETF) is a diversified collection of assets (similar to mutual funds) that trades on an exchange (like a stock). However, unlike most mutual funds that depend on the manager's stock-selection capabilities to try to achieve market-beating returns, most ETFs are based on passive market indices such as the Dow Industrial Average ETF (DIA), the S&P Technology Sector ETF (XLK), or iShares MSCI Brazil ETF (EWZ). These ETFs own a portion of every company in the indices upon which they are based and don't try to beat any market benchmark. That's because they ARE the market benchmark – by design!
Some people compare investing with individual stocks to betting at the beginning of the season on who will win the Super Bowl many months later. Continuing with this analogy, investing in passive, index-based ETFs would similar to owning the entire National Football League (NFL). If you were bullish on the sport of football, you could own part of the entire NFL instead of an individual team and you would make money off of a portion of all the revenue from all the teams collectively – regardless of which team wins the Super Bowl each year.
Furthermore, if you owned an individual football team, there's always the chance of some freak event severely damaging your revenue stream at some point, such as Hurricane Katrina flooding the Superdome in New Orleans and shutting down all play in that stadium for years. However, if you owned a portion of the entire NFL, you know that can never happen. Under which scenario is there a higher chance you will make money at the end of each season?
Perhaps the payoff is bigger if you are lucky or smart enough to pick the team that's going to win the Super Bowl, but for most people, the answer is that they would obviously have a much better chance of making money in the long run by owning a portion of the entire NFL. However, few investors want to think of stockpicking as betting on which team will win the 'investment Super Bowl' as a way to save money for retirement, but the similarities are clear.
Most prudent individuals, when determining the best path to achieve their long-term savings and wealth-building goals, would choose to own the equivalent of the entire NFL. To take the analogy one step further, at some point in your career you may become a baseball fan and decide the baseball has better prospects. You can always sell your ownership in the NFL to buy into the Major League Baseball.
In the investment world, this would be the equivalent of buying shares of the more aggressive Technology Select Sector SPDR (XLK) as you begin your professional career in your 20s, and then selling those shares when you reach your 40s to buy the more broad-based S&P 500 ETF (SPY) for the second half of your career. Either way, you almost can be sure those shares are going to be significantly higher than they were when you bought them.
Accelerating Demand for Exchange Traded Funds
Back in 2007, just before they began to surge in popularity, ETFs had about $500 billion in assets under management (AUM). At that time, mutual funds dwarfed them at about $17 trillion AUM. Today, assets invested in ETFs is closing in on $4 trillion spread across more than 5,000 ETFs worldwide. The size of the ETF market is expected to surge past mutual funds in the coming years, reaching $20-$25 trillion AUM by 2025. In 2017 alone, $1.3 trillion flowed into ETFs. Much of that money is coming out of mutual funds, and individual stocks as more and more investors become convinced of the benefits of ETFs.
With accelerating annual growth of more than 20% per year, ETFs are, by far the fastest growing investment product in history, claiming the mantle as the preferred investment for investors of all experience levels and styles. This massive transfer of wealth, the largest in human history, has created a generational shift in the investment world. ETFOptimize exclusively uses Exchange Traded Funds in our systematic, quantitative trading strategies.
What are the Advantages of ETFs?
The explosive growth for ETFs has not come without reason. Compared to buying individual stocks, ETFs provide the advantage of instant and robust diversification in a single, easy-to-use position. To match an ETF without the benefit of their structure would require an individual investor to own hundreds or even thousands of different company stocks. Furthermore, ETF investors are never a victim of abrupt price swings caused by company disappointing earnings announcements, management upheaval, or accounting scandals that all too regularly haunt self-managed investors.
Here are a few of the myriad advantages of ETFs over mutual funds and individual stocks:
• Diversification: Like mutual funds, most ETFs hold hundreds or thousands of individual stocks, thereby providing instant diversification across an entire index of assets. Even the purchase of a single ETF share provides instant ownership in a large number of securities. ETFs offer exposure to a wide variety of markets including broad domestic indices, international and country-specific indices, sector and industry-specific indices, bond indices, and commodities. Any segment of the market can be targeted by our systematic strategies whenever they are the best selection for that point in time.
• Eliminate Individual Company Risk: An ETF will never go out of business because their product is obsolete, never file bankruptcy because a new technology disrupted their market, never get turned down by the FDA for approval of an important drug product, and will never be involved in an irrationally conceived merger. In other words, because ETFs hold hundreds or even thousands of individual company stocks that populate established market indices, they eliminate the individual-company risk that traditional stock investors face. The purchase of a single share in an ETF provides you with diversification across hundreds or even thousands of individual companies, so there's no need, from strictly the standpoint of diversification, to hold more than one ETF in your investment portfolio.
• Flexible: Unlike mutual funds that usually have minimum investment requirements of $2,500, $3,000 or even $5,000, you can invest any amount in ETFs, even purchasing just one share for as little as $10 or less (most ETFs keep their price per share around $30-$50).
• Convenient: Unlike mutual funds, ETFs trade throughout the day like a stock, making them easy to use on your terms. Your funds are always available whenever your broker is open, should you have to access funds quickly for an urgent need.
• Low Cost: Mutual funds fees average about 1.45% of assets per year, with some costing as much as 10% of assets per year, while the average management cost of an ETF is just 0.30%, with the upper end of the range at about 0.90%. Plus, many ETFs can be traded commission-free (check with your broker).
• Transparency: ETFs are required to publish a list of their holdings each business day. This provides openness of where the fund's money is invested at an unprecedented level compared to mutual funds, hedge funds, and other fund types that can essentially be black boxes.
• Liquidity: You can buy or sell the ETFs used in the ETFOptimize strategies, whenever the market is open. ETFs don't have liquidity issues that stocks or mutual funds can have because an ETF is created or redeemed in large lots, as needed, institutional investors throughout the day. The sale of an individual stock is dependent on finding a buyer on the other side of the trade, which can be a significant problem for thinly traded, small equities.
• Tax-friendly: Because of frequent, internal trades that generate capital gains throughout the year, tax laws notoriously punish mutual funds. ETFs on the other hand, track an established index and make 'in-kind' trades that minimize capital gains and provide investors with a tax-efficient structure.
• Targeting: This benefit is not usually included in list of ETF advantages, but today there are about 4,000 ETFs representing probably 2,500 - 3,000 different market indices provides an incredible opportunity for investors. The ability to invest in an entire asset class, an entire industry, or all the stocks in an entire country at any particular point in time when the investor believes that group is going to excel his phenomenally powerful. However, having all of these choices can be a double edge sword.
Unlike mutual funds, which holdings are usually secretive until a quarterly report is required, Exchange Traded Funds (ETFs) have the advantage of being completely transparent, with the legal requirement to publish every investment owned by the ETF at all times. With index-based ETFs, “if you pick up a newspaper and see how the S&P performed, you will know how your portfolio did,” says Illinois State Board of Investment Chairman Marc Levine. “They provide perfect transparency.”
ETFs give retail investors access to low cost investing in assets that simply wouldn't have been possible before, such as an investment in actual gold or oil. Prior to the introduction of physically-backed ETFs, a person wanting to own gold would have to buy the actual gold bars and incur the cost to store them in a secure location. However, today there are more than 10 gold ETFs that are physically backed by the actual asset, led by the SPDR Gold Trust (GLD), which has more than $35 billion in assets. Plus investors can access very esoteric and often exotic investment niches such as investing in real estate in Japan – through the Japanese Real Estate Fund (DXJR) or investing in the growth of cyber security software – through the ETFMG Prime Cyber Security ETF (HACK), with $1.2 billion in assets.
Some of the features which are advantages of ETFs for most investors can be unattractive for a few. For example, flexibility and selection are desirable for most investors, but those with poor judgment and discipline might outthink themselves by making too many trades, and since there are fewer restrictions to trading ETFs compared to mutual funds, an undisciplined person could get frantic with their trading. Of course, that's also possible with individual stock trading.
However, if subscribers closely follow our ETFOptimize quantitative ETF trading signals, they will not be making transactions too frequently. Our strategies rotate positions with an average of 2 to 7.2 months between trades (depending on the strategy). Of course, an investor won't be choosing the wrong ETF out of the seeming multitude of options because the ETFOptimize models are designed to always determine the most profitable, optimum ETF to own at any point in time.
A Significant Appeal to Cost-Conscious Investors
Playing a prominent role in today's migration to passive investing is the significant difference in the level of fees for ETFs versus the fees for mutual funds, hedge funds, and other active approaches. The average ETF carries an expense ratio of 0.44%, which means the fund will cost you just $4.40 in annual fees for every $1,000 you invest. In contrast, the average mutual fund expense ratio is about 1.45% in stated fees – more than triple the cost of ETFs – according to a recent study published in the "Financial Analyst Journal."
While a 1.45% fee may not seem like much, it alone can trim a retiree’s nest egg from $1,199,093 to $904,081 – a cost of $295,012. Those figures assume a $10,000 investment per year compounded at (a very generous for a mutual fund) 7.5 percent annually for 30 years. That 1.45% average mutual fund fee would reduce by nearly 1/4 the amount you would have at retirement! Now here’s the real kicker: including all of the hidden fees associated with mutual funds, the total cost of ownership can be 6.22% annually for a taxable account, according to a September 2016 Forbes piece, "How Much Do Mutual Funds Really Cost?"
Many of the largest brokers offer free commissions when trading Exchange Traded Funds (ETFs). The following table, published by Vanguard, shows a scenario of brokerage costs incurred while trading individual stocks versus the cost of trading ETFs:
Check with your broker to see which ETFs they have designated for commission-free trading. If your broker does not offer commission-free ETF trading, you might want to switch to a broker that does. Unfortunately, to date there are no brokers that offer completely free ETF trades across a broad spectrum of the most popular ETFs, but that may change as the trend towards disintermediation continues.
The Mutual Fund Era: 1980-2005
Most working professionals usually aren't experts of the investment world in addition to their professional expertise. Even if they do spend years learning about investing, they don't have access to all the data and inside information that's available to professional money managers.
Therefore, the vast majority of non-professional investors historically turned to trained 'experts' – professional money managers and mutual fund managers – to handle the task of investing their hard-earned savings. These professionals combined saver's nest eggs with thousands of other saver's funds and chose the stocks that they believed would have the best prospects for gains in the future. This discretionary approach makes mutual funds 'actively managed' investments.
In the past, mutual funds were usually the only investment offerings that were sponsored by corporate employers. In the 1980s and 1990s, the popularity of mutual funds surged, and the percentage of US households that owned mutual funds rose dramatically from 4.6% in 1980 to 45.7% in 2000. However, beginning in 2005, the mutual fund growth boom fizzled out and since 2013 has flatlined at about 45% of all US households with ownership in a mutual fund.
Because of mutual fund manager's consistently rotten track record over long swaths of time...
Unfortunately, the promise of experts managing investor's money has not met expectations. According to the latest 2016 release of Dalbar's Quantitative Analysis of Investor Behavior (QAIB), the average investor in a blend of equities and fixed-income mutual funds has garnered only a 2.6% net annualized rate of return for the 10-year period ending Dec. 31, 2016. Counterintuitively, over longer time frames, the results aren't any better. The 20-year annualized return comes in at 2.5%, while the 30-year annualized performance is just 1.9%. (Read more about the generational shift in the investment world – from mutual funds to ETFs…)
The Historically Poor Performance of Mutual Funds
The track record of mutual funds tell a very different story that shows the promise of "professional management" is merely marketing hyperbole:
Embarrassing Fact #1: 94% of mutual fund managers underperform the broad market over 10-year periods. Over 30-year spans the stats are even worse: 98% of fund managers underperform the market – and the last 30 years were not particularly unique, as this dismal record has been the case for many consecutive decades.
Embarrassing Fact #2: The average investor using a blend of equity and fixed-income mutual funds has garnered only a 2.6% net annualized rate of return for the last 10-years. Moreover, over more extended time periods the results aren't any better. The 20-year annualized performance is 2.5%, while the 30-year annualized rate for the average investor is just 1.9%. That's just plain bad, especially when you consider that the most well-known stock market index (the S&P 500 large-company index) grows by an average of about 7.5% per year.
In addition to the historically poor track record of discretionary mutual fund managers, individual investors who use mutual funds commonly have the same cognitive biases and make the same behavioral errors that mutual fund managers make, thereby aggravating and multiplying this dreadful performance.
For example, many investors will search for the best performing mutual fund for the last year, or the previous three or five years, and choose what they believe is the best, 'expert' manager for the long-term, based on recent performance.
The average investor also determinedly avoids funds with recent poor performances. Unfortunately, many studies show that funds that have recently been on a great run were usually only there temporarily and inevitably perform poorly in subsequent years, thereby reverting to their average, long-term performance, while funds that recently performed relatively poorly usually make up that ground with excellent performance in the following years. As we have said many times in our editorials, reversion-to-the-mean is the most powerful force in investing.
Individual investors inevitably do with mutual funds the same thing they do with individual stocks: buy the winners and sell the losers. When these mutual funds and stocks revert to their mean, it results in investors who have ultimately bought at a high, and then they sell after a downturn to stop the bleeding – the opposite of what they should be doing to be successful investors. As a result, over the long-term, individual investors have an average, after-inflation performance of -1.16%. Negative!
It is because of these uncontrollable, subconscious, behavioral errors that haunt virtually every investor – regardless of whether they are rank beginners or seasoned veterans – that passive, index-based Exchange Traded Funds (ETFs) have gained such overwhelming popularity.
The Emergence of Exchange Traded Funds (ETFs)
The story of Exchange Traded Funds (ETFs) commenced when the first ETF was created for the Canada market in 1990. Investment companies in America saw how popular it was and requested approval from regulators to launch the new investment product, led in 1993 by the Standard & Poor's Depository Receipts (SPDR) 500 Large-Cap Stock Index ETF (SPY). Now part of an ETF series known as SPDRs or "Spiders," the fund is based on the most popular and prolific market index *S&P 500 index) and ultimately became the most succesful ETF in the world with $270 billion of assets under management, invested in the 500 largest publicly traded companies in the United States.
In May 1995, S&P followed up with the introduction of the mid-cap SPDRs (MDY). Barclays Global Investors was the next entry into the market in 1996 with a product that ultimately became the iShares Index Fund Shares, which track the Morgan Stanley MSCI 17 country indices, giving casual investors easy access to foreign markets, which was difficult if not impossible before to this product introduction.
This new investment product type was familiar to investors in some ways. ETFs are similar to mutual funds because the purchase of a single share provides substantial diversification across dozens, hundreds, or even thousands of individual stock holdings. That's because ETFs, by law, hold a minimum of 26 stock, bond, or option investments, with the average index-based ETF holding hundreds of stocks. But that's where the similarity ends. Unlike mutual funds that are only priced and traded at the end of the business day, Exchange Traded Funds have the advantage of trading like stocks; i.e., they can be purchased and sold at any time throughout the day whenever the market is open.
For many investors, the real advantage comes because, unlike mutual funds where a fund manager determines the stocks held in the fund, 97% of ETFs passively follow a market index.There are many hundreds of market indices from which to choose, ranging from a broad index of America's premier, most significant businesses, such as the S&P 500 ETF (SPY), to a cutting-edge, US biotechnology stock ETF (XBI), to an emerging-market Internet and e-commerce ETF (EMQQ), to a triple-leveraged Japanese government bond ETF (JGBT). If you can think of any business category, country, niche or style, it's likely there's an index for it and an ETF based on that index.
In early 2007, when we began designing strategies that used them, the Exchange Traded Funds (ETFs) market had about $500 billion in assets under management (AUM), while mutual funds had nearly $17 trillion AUM. Today that relationship is rapidly reversing, as assets invested in ETFs are closing in on $4 trillion and is expected to reach $20-$25 trillion AUM in just seven short years (2025). ETFs currently hold about 35% of all assets under management in the United States (in Japan, the figure is 70%). Meanwhile, money flowing into mutual funds is shrinking as demand for that investment vehicle wanes.
ETF Assets under management are growing at a phenomenal pace of 24% per year since 2003.
Following the introduction of the first Exchange Traded Fund's in 1993 with the S&P 500 ETF, (SPY), more investment companies entered the market and added new variations to the ETF product lineup. ETFs began to accumulate assets rapidly and took off as an investment vehicle around the time of the 2007-2009 'Great Recession.' That's when investors saw how effective ETFs could be to provide instant diversification – or even the ability to earn profits when other investors were losing money – by using inverse ETFs that profited from the market's volatile tumbles during that crisis.
Some sponsors construct a product called "inverse ETFs" using derivatives to profit from a decline in the value of the underlying benchmark. There are also "leveraged ETFs," which allow an investor to double or triple the return of an index, and even inverse-leveraged ETFs, which provide a multiple of the inverse of the performance of a particular index.
Because of their flexibility and ease-of-use in accessing hard-to-reach market niches, Exchange Traded Funds (ETFs) have become the fastest-growing product in the history of the financial industry.
Exchange Traded Funds (ETFs) offer the advantage of trading like stocks while providing diversified exposure to virtually every investible asset class, including all segments of the equity and bond markets, individual market sectors, various industries, commodities, precious metals, currencies – plus international versions of all the above.
With ETFs, you can access nearly any market segment you can imagine. Over the last decade, tens of millions of investors have discovered the many advantages that Exchange Traded Funds (ETFs) have over individual stocks and mutual funds. As a result, the market for ETFs has exploded. In fact, according to Credit Suisse, 14 of the 15 most actively traded securities last year were ETFs, and a single ETF, the S&P 500 SPDR (SPY) has about $270 billion of assets under management – by far, the most popular investment in the world.
ETFOptimize combines today's most popular investment vehicle (ETFs) with high-performance, quantitative strategies that you can use to successfully manage the funds in your account to achieve your wealth-building goals. Each of our strategies includes a Ranking System component that each week automatically analyzes more than two dozen data series to determine the most profitable ETF to own at any given point in time.
Our sophisticated approach to ETF selection that combines macroeconomic analysis, analysis of market internals, and fundamental stock analysis into a single decision-making process is a first for any investment service of which we are aware. By combining what may be the two most valuable investment ideas of modern times (ETFs and quantitative strategies) with an innovative, breakthrough approach that slashes drawdowns and turbocharges returns, ETFOptimize offers an investment product that checks every box on an investor's wish list.
When investing with ETFs, you are effectively "buying the entire NFL" rather than trying to "pick the next Super Bowl winner" in a single stock as a way to achieve your wealth-building goals. However, when using ETFOptimize's proven, systematic investment strategies, an investor may effectively be attaining the probability of success of "buying the entire NFL," while also achieving the outstanding performance of "winning the Super Bowl" – simultaneously, and in one easy-to-use package!