INTRODUCTION


Why ETFs are Today's Investment of Choice


Advantages of ETFs Over Stocks and Mutual Funds

 

Why ETFs are Today's Investment of Choice

 

Exchange Traded Funds (ETFs) are powerful investment tools that have become the most popular trading vehicle available today. In fact, in 2018 investors are expected to pour more than $400 billion into Exchange Traded Funds (ETFs), and the pace of the inflow of money is accelerating. Goldman Sachs forecasts that ETF inflows will surge 33% in 2018, from 2017's already lofty level of about $300 million. The result is a generational shift of financial assets of immense proportions.

The vast majority of new money – and a sizable portion of already-invested money – is pouring into ETFs, with the most popular investment of the last generation – mutual funds and individual stocks– seeing their prospects dim as investors move funds out of those vehicles and into ETFs. In 2018, Goldman Sachs projects ETFs to see inflows of $400 billion, a 33% increase over 2017's  inflow. Meanwhile, mutual funds are projected to experience net selling of $125 billion on top of 2017's $100 billion.

ETFs are like Mutual Funds, in that they purchase a diversified collection of asset, but unlike Mutual Funds, they trade on an exchange (like a stock).

Perhaps the most prominent distinction between the two is that mutual funds depend on an investment manager's stock-selection prowess to try to achieve acceptable returns using discretionary selection of individual stocks. On the other hand, most ETFs passively duplicate the performance of market indices such as the S&P 500 SPDR ETF (SPY), the Dow Industrial Average ETF (DIA), the S&P Technology Sector ETF (XLK), or iShares MSCI Brazil ETF (EWZ) and several thousand more indices and ETFs from which to choose.


Analogy: Betting on a Single Team – or Entire NFL?

Some people compare investing by selecting 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 be similar to owning the entire National Football League (NFL). If you were bullish on the sport of football, you might choose to own part of the entire NFL – instead of an individual team. This way, 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 that some freak event could upend your investment, such as Hurricane Katrina flooding the Superdome in New Orleans and shutting down all play in that stadium for many years. However, if you owned a portion of the entire NFL, you know that can never happen. A disaster affecting one individual team is mitigated by the collective performance of all the rest. So, under which scenario is there a higher chance you will make money at the end of each season?




 The demand for equities by ETFs is increasing since 2004 – and accelerated upward again beginning in 2016 – as investors poured money into their favored investment vehicle. Meanwhile, mutual funds are bleeding assets.
Source: Federal Reserve Board, Goldman Sachs Global Investment Research


Perhaps the payoff is bigger if you are lucky or smart enough to pick the team that's going to win the Super Bowl (or at least make the divisional playoffs), but most people would agree it's obvious they 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 undeniable. And even if you aren't picking the stocks for your own account, it's likely a mutual fund manager or similar approach is a proxy you have assigned to pick those stocks for you.

Most prudent individuals, when determining the best path to achieve their long-term retirement savings and wealth-building goals, would logically choose to own the conservative equivalent of owning the entire NFL. It's logical that, even if the returns are lower than the best-case scenario of successful stock-picking, a person that is consistently contributing to passive, index-based ETFs is assured of having a solid, sizable retirement account at the end of their career.


The Mutual Fund Era: 1980-2005

Most working professionals are not interested in becoming experts in the investing in addition to their core expertise. Even if they do spend years devoted to learning about investing, they still don't have access to the extensive databases, economists and individual stock analysts on staff, research teams, and a plethora of other resources that are available to professional money managers.

Therefore, the vast majority of non-professional investors historically turned to 'experts' – mutual fund managers and other professional money managers – to handle the task of investing their hard-earned savings. These professionals combine their savings with thousands of other saver's funds and chose the individual stocks that they believe will have the best prospect 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 fund manager's consistently rotten, collective track record
over many decades, investors are abandoning mutual funds...


Unfortunately, the promise of experts managing your assets has not come close to meeting investor's expectations. According to the latest 2017 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 Dalbar study and the generational shift in the investment world – from mutual funds to ETFs…)

Goldman Sachs reports that high cost and poor returns are the blame for the shift from active mutual funds to passive 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:  More than 50% of mutual fund managers underperform their closest market benchmark every year, and 97% underperform over 10-year periods. Over 30-year spans the stats are even worse: 99% of fund managers underperform benchmarks – and the last 30 years were not particularly unique, as this dismal record has been the status quo for many decades.

Embarrassing Fact #2:  The average investor using a blend of professionally managed equity and fixed-income mutual funds has garnered only a 2.6% net annualized rate of return for the last 10-years. Moreover, across 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 terrible, especially when you consider that the most well-known stock market benchmark (the S&P 500 large-company index) grows by an average of about 7.4% per year – and long-term inflation is at 2.4%.

Embarrassing Fact #3:  Since 2009, not a single mutual fund has beaten the S&P 500, the most widely used market benchmark, which includes 80% of all stock market capitalization. During a time of the 2nd most extended bull market on record, the S&P 500 has climbed 305% (more than quadrupling its value) and has produced an annual return of 16.41% (more than double its long-term average annual return). However, during this bullish run of the market, not a single mutual fund manager was smart enough (or in enough control of their emotions) to pick the top stocks that would beat that 500-stock index.


Investors Using Mutual Funds Compound the Problem

In addition to the historically poor track record of discretionary mutual fund managers, individual investors who use mutual funds typically have the same cognitive biases and make the same behavioral errors that the mutual fund managers make – thereby aggravating and multiplying this dreadful situation.

As an example of the mistakes made, 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 with the best fund for the long-term (based solely on the recent performance of the fund).

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 will perform poorly in subsequent years.

An asset's price reversion-to-the-mean (or the average), long-term performance is one of the most common characteristics of investments. Funds that recently performed relatively poorly usually make up that ground with excellent performance in the following years, and vice-versa for investments that have been riding high for some time. As we have said many times in our editorials, reversion-to-the-mean is the most powerful force in investing.

However, individual investors inevitably do with mutual funds the same thing they do with individual stocks: buy the winners near their top and sell the losers near their bottom. 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 average equity and fixed-income, mutual fund investor has an average, long-term, after-inflation performance of -1.16%.  That's a negative real performance!

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. Investors are learning to stop trying to beat the market because it is nearly impossible – and this applies to veteran investors with 20-years experience or newbies with 20-minutes experience.


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.

ETF CHARACTERISTICS

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.

INCREDIBLE GROWTH

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 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.


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.



The pace of funds coming out of active investments and into passive ETFs is accelerating.


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.


The Advantages of ETFs

The explosive growth for ETFs has not come without a good 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 individual company stocks. Furthermore, ETF investors are never a victim of abrupt price swings caused by a company's disappointing earnings announcement, management turnover, regulatory disapproval, or the accounting scandals that all too regularly haunt individual stock 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, never have management that drains the company's funds for their own benefit, 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, strictly from 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 just 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 that disclose holdings just four days a year. For the other 361 days, mutual fund holdings are opaque.

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, by 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: Today there are about 4,000 ETFs worldwide that represent about 2,500 - 3,000 different market indices. This plentiful selection provides an incredible opportunity for investors to target different market niches and take advantage of the rotational nature of markets. The ability to invest in a specific asset class, a specific sector, a specific industry, or a specific country at any particular point in time when the investor believes that group is going to excel is a phenomenally advantage – one we make full use of with the ETFOptimize strategies. Our proprietary algorithms determine what portions of the market are set to excel and then rotate to the specific ETF that will take maximum advantage of that fundamental rotation.


Ownership percentage in the stock market


Even though ETFs are the fastest-growing portion of the market, they still comprise just 6% of stock ownership.
Obviously, there is an enormous amount of potential for growth.
Click to Enlarge.


Unlike mutual funds, which keep holdings secretive until a quarterly report is required, Exchange Traded Funds have the advantage of being 100% transparent because the rules require them to publish every investment owned by the ETF at the end of every trading day. With index-based ETFs, “if you pick up a newspaper and see how the S&P performed, you will also 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 investment in assets that simply wouldn't have been possible before, such as owning and safely storing actual gold bars, barrels of crude oil, or bushels of corn. 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), which has $1.4 billion in assets.

Potential Disadvantages

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.

Conclusion

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 quantitative 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 "owning the entire NFL" rather than trying to "pick the next Super Bowl winner" using individual stocks(or allowing a mutual fund manager to pick stocks for you) 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 diversity and probability of success of "owning the entire NFL," while also achieving the outstanding performance of "owning the winning Super Bowl team" –  simultaneously, and in one, low-cost, easy-to-use package!

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