Why I Prefer ETFs

Hopefully we all know what Exchange Traded Funds are, better known as ETFs. I don’t know why, but I thought I would share a few reasons why I prefer the use of ETFs for my clients. Below are a bunch of the reasons in no particular order.

• They are a much lower cost product than actively managed mutual funds. I don’t have an exact number to compare, however, I am comfortable saying the average ETF fee is ¼ of the fee for an actively managed mutual fund. So, instead of paying 1% a year for actively managed funds you pay roughly .25% for an ETF. That difference stays in your portfolio growing year after year.
• ETFs trade like stocks. Mutual funds settle at the end of the day while ETFs can settle during the day once the trade is executed. This makes a difference if you are putting in a trade request on a volatile day and don’t want to wait to the end of the day hoping the price at which you entered your trade is the same hours later when the market closes.
• ETFs are much more tax efficient. It is that time of year when mutual funds send out their capital gains distributions. This can be a rather unpleasant tax hit for many mutual fund investors. ETFs have a different design where most avoid capital gains distributions.
• Tax-loss harvesting is much easier with ETFs. Short version is if you hold an ETF in a taxable account that is down, you can sell the holding, grab the tax losses, and reinvest the proceeds into another ETF that is similar (but not identical) to the one you just sold for a loss. All without violating wash sale rules. This is what I can only describe as a loophole in the tax treatment of ETFs and it may get closed at some point, but for now it is there for our benefit.
• The worry of underperforming the index is now gone with most ETFs (unless you buy some exotic type). Yeah, you won’t outperform the index either, but that’s not the purpose of ETFs. They are to match the index.
• I thought I would share some 20-year SPIVA data (S&P Indices vs Active):
1. Most active managers (mutual funds) underperform most of the time.
2. This is true net or gross of fees.
3. Most institutional managers also underperform most of the time.
4. After adjusting for risk (which is what active managers brag about), most active managers underperform most of the time.
5. Data is similar when you look at active managers for fixed income and international investments.
6. The longer the time period the better the odds for underperformance. This means funds that have a good year or two typically underperform subsequent years.
•  Let’s look at picking individual stocks. One study showed the best performing 4% of listed companies explain the net gain for the entire US stock market from 1926 through 2016.
• Another finding was eye-opening. There have been nearly 29,000 companies that traded on US markets since 1950. By 2009, nearly 80% of these companies no longer existed.
• Half of all companies in any given cohort of publicly traded companies cease to exist within 10 years.
• None of the 20 companies that were part of the Dow Jones in 1920 are still in that index.
• From 1980 through 2014, 40% of the companies in the Russell 3000 (3,000 largest US traded stocks), were effectively failures. But 7% of components of the index were strong enough to help offset these 40% of failures and provide a 73-fold increase in this index during that time period.
• I don’t know any investor who was good enough to identify those 7% components and totally avoid the 40% that went under.
• Finally, a large percentage of managers of actively managed mutual funds do not even invest in their own funds. If it isn’t good enough for them, why would you invest there?

I’ll stop here. There are lots more reasons I can share why I prefer ETFs for most investors. However, I am sure I have bored you enough. If I were to whittle this down to why most investors should use ETFs over actively managed mutual funds and individual stocks it would be – lower costs, tax efficiency, and matching the indices for their performance.

I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.