Exchange Traded Funds (ETFs)

An Exchange Traded Fund (ETF) is a diversified collection of assets (like a mutual fund) that trades on an exchange (like a stock). ETFs are easy to use, lower in cost than mutual funds, and more tax efficient than alternatives.

ETFs are powerful investment tools that have become the most popular trading vehicle available today. In fact, this year investors are expected to pour nearly $1 trillion into Exchange Traded Funds (ETFs), and the pace of the inflow of money is accelerating. This is largely the result of  investors shifting a significant portion of assets from active, discretionary approaches to passive approaches. The result is a transfer of financial assets of immense proportions – of a magnitude the investment industry has never before seen.

The largest proportion of new investment funds are being directed into ETFs, and the most popular investments of the last generation – mutual funds and individual stocks – are seeing their prospects dim as investors move funds out of those investments and into ETFs.

There are myriad reasons for the unprecedented popularity of ETFs, including lower costs, improved transparency of holdings, better intraday liquidity compared to mutual funds and stocks, and the fact that 98% of ETFs are passive investments based on established market indices, such as the S&P 500 index (ETF symbol: SPY). Investors see this as a significant benefit because, after decades of poor performance by mutual funds and individual stock picking, investors are wholeheartedly embracing passive, index-based investments – which usually outperform stockpicking at one-twentyth of the cost and virtually no time investment.

Defining Exchange Traded Funds

For those new to Exchange Traded Funds (ETFs), we offer this description:

ETFs are pooled investment vehicles that provide diversified exposure to various segments of the market. ETFs can own stocks, bonds, commodities, currencies, options, and physical assets. When investors purchase the shares of an ETF, those shares represent a proportional interest in the pooled assets of the ETF.

ETFs are similar to mutual funds in that they can provide you with instant diversification in a single position (because they hold dozens, hundreds, or even thousands of shares of individual stocks or other assets mentioned above). This eliminates the individual-company risk that wreaks terror in the hearts of investors.

Note that some ETFs own physical property such as gold bars, bushels of wheat, or barrels of oil, and this feature offers a way that investors can hold these tangible assets without having to deal with storage, security, and other issues that in the past made it prohibitive.

Another aspect of ETFs that was not available before was the ability to own a portion of the corporations in foreign countries, such as Brazil, Japan, Germany, emerging markets, etc.

A well-known TV personality has a trademark saying of, "There's always a bull market somewhere!" That's true, and with ETFs, you have instant access to those bull markets any time you choose. ETFOptimize's job is to identify the bull markets and avoid the bear markets, making steady profits every year (57 of 57 consecutive profitable years for our strategies)!

 Advantages of ETFs

ETFs are far more flexible than mutual funds because they can be traded like stocks – that is, ETFs can be traded anytime throughout the day while stock exchanges are open. You can buy an ETF at 10 AM, sell it at noon, and rebuy it at 2 PM. This is where ETFs get the 'exchange traded' aspect of their name and this flexibility is one of the significant differences between ETFs and mutual funds.

Unlike mutual funds that trade once a day at a set price based upon asset value, ETFs are traded in your brokerage account just like a stock, and their price is partially based on net asset value and partly on supply and demand for the ETF (similar to stocks).

Perhaps the most notable advantage for ETFs is another way in which they are unlike mutual funds. You see, most mutual funds rely on a mutual-fund manager to choose the individual stocks the fund holds. That means that the performance of the mutual fund depends upon the capabilities of the investment manager. Unfortunately, the mutual fund management profession may be one of the least successful careers ever. That's because fully 98% of mutual fund managers are unable to outperform passive stock indices, such as the S&P 500, or a benchmark that is closely related to the mutual fund.

Instead, the vast majority of Exchange Traded Funds (ETFs) are passive investments that closely track established market indices – such as the S&P 500 SPDR ETF (SPY), the S&P Technology Sector ETF (XLK), Emerging-market ETF (EEM), Japan ETF (EWJ) and more than 2,000 additional ETFs.

Cost: As a result of ETFs being based on market indices and not on aE so-called 'expert's' stock choices, ETF's are one-third the price of the typical mutual fund (and 1/10 the cost of many of the more expensive mutual funds).

Owning a Piece of the Market Through ETFs

Because ETFs are based on established, passive market indices that slice-and-dice individual stocks into a myriad number of discrete groups, (for example, you can buy the S&P 500 technology-sector stocks in a single ETF -XLK) ETF investors entirely avoid the individual-company selection errors that consistently destroy returns for so many investors.

Instead, many investors today, after experiencing decades of mutual fund underperformance, have given up on investing to beat the market. Instead, many investors buy shares in an index-based ETF and thereby own a piece of the market itself. With this approach, you're not going to outperform the market – but you're also not going to underperform it either, and for most people, that's a big step in the right direction.

Adding a Slight Bit of Activity

ETFOptimize adds a slight bit of activity (transactions occur a bit more than three times per year, on average) to passive ETF investing. Through the use of sophisticated quantitative strategies that instantly assess conditions every week, each strategy rotates to the optimum ETF position for its approach. The result is an advantage for the ETFOptimize strategies that is nearly quadruple the annual return of the S&P 500 – and a reduction in maximum drawdowns to less than one-third the max drawdown of the market.

By reducing or eliminating the drawdowns that destroy returns – and always owning the optimum asset at any given time, the result is an average performance that nearly quadruples the return of a passive investment in a market index, such as the S&P 500 SPDR (SPY).

By subscribing to an ETFOptimize strategy, investors will receive notifications of the optimum time to rotate from one ETF to another and always achieve the highest performance. Transactions occur slightly more than three times per year, so this approach is close to passive, but the investor avoids significant market downturns and often is making a profit while fellow investors are losing money.

For more information on how ETFs are different from your other investment options, see our article, "Why Investors are Choosing ETFs Over Stocks and Mutual Funds."

To learn more about Exchange Traded Funds (ETFs), Systematic Investing, and the advantage of using ETFOptimize, please see our introductory articles.

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