Through a glass, darkly

Recently accused of seeing the glass half-empty instead of half-full, I replied that the analogy was not a good one for the issue at hand. I couldn’t even find the glass being discussed and so really had no insight as to the contents. Similarly, the newest breed of ETFs (Exchange Traded Funds) have begun to look a lot like the mutual funds, and even hedge funds, they were supposed to replace. It isn’t that any particular ETF is good or bad, the question needs to be what is in the ETF.

We’re big fans of ETFs at Invest-Notes, and have been for several years. Yet what they originally were versus what many are becoming is a concern to be aware of. In a nutshell, an ETF is a portfolio of (usually) equities that matches a common benchmark. The most well-known example is the Dow Jones Index, a collection of the forty biggest and most recognizable companies in the United States. Another major index is the S&P 500 (the preferred proxy for the overall market here at Invest-Notes), which includes most of the Dow components and another 350, or so, companies meeting requirements about market capitalization and share price. The single biggest ETF is also one of the first, SPY, which mirrors the S&P 500 index.

So, it should be pretty straight forward. You purchase an ETF that holds the same stocks that are in the index. Because the fees for these funds are typically a fraction of the cost of similarly structured mutual funds, they provide a better return (or less loss of capital in down markets). Since equity markets have a long history of going up more than they go down over time (up 60% of the time, down 40%), investors see improved returns. Ideally, an investor decides where they are most comfortable – and suitably diversified – making regular contributions over time.

But there are now a lot of ETFs without indexes, holding low quality bonds, physical gold (bullion and coins) as well as foreign stocks and bonds from other countries. This helps explain the recent news about troubles at some new ETFs that invest in very small companies, assets that can be hard to sell, or even other tightly focused ETFs.

One particular story revolves around gold-focused ETFs finding it hard to invest all the money that had been pouring in as gold caught a bid this spring. Some funds were buying physical gold, but also small gold mining stocks and even other ETFs also holding the same assets. Needless to say, all the folks rushing into gold ETFs as they went up have recently tried to get out as the price moves the other way. This in turn has caused some serious gyrations in the market. Can a glass be half full of itself?

Now we have a simple idea – low cost funds tied to recognized benchmarks – being made more and more complex in order to attract buyers as well as providing excuses for additional layers of fees. And, much like the manipulation of home mortgages by investment banks that became gasoline fueling the financial meltdown of 2008-2009, there are now ETFs that have gone bad. Caveat emptor, indeed.

Yet there are a couple of simple solution. ETFs are not stocks to be bought and sold – they are intended to be long term holdings that increase wealth over time. Forget the idea of market timing in the ETF arena and avoid jumping on the hot play of the day. Both my kids both started IRAs last fall and asked for suggestions on how to get started. Again, I recommended keeping it simple:

An S&P 500 ETF – VOO (though I prefer RSP) = 50%

An all-world fund with no U.S. stocks – VUE = 25%

A small cap fund to counter-balance the large cap stocks that dominate the S&P – VBR = 25%

Last year a three-part series giving the history of ETFs and how they work was posted here on Invest-Notes. For those wanting more information:

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One Response to Through a glass, darkly

  1. Rick Grinnan says:

    let’s have lunch my friend. we can afford it! lot’s of whine, I mean wine.:)

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