Solas!: The Advantages of Using ETFs in Client Portfolios

My clients have different investment goals, time horizons and risk tolerances. The challenge is to develop portfolios that are a reflection of these differences. One of the underlying tools I use in client portfolio development is Exchange Traded Funds (ETFs). I value ETFs because they trade like stocks, generally have lower expense ratios than mutual funds, enable portfolio diversification, and offer clients the ability to take less risk than traditional stock portfolios.

Trade Like Stocks

Unlike other types of equity vehicles, such as mutual funds, ETFs are traded similar to stocks throughout the day instead of only one pricing at the close of business. Since they are priced like stocks, their value changes constantly depending on supply and demand.

This stock-like quality allows me to actively create a game plan that can take advantage of market discrepancies when trying to find the best values for my clients.^{^[1]} Because ETFs trade like stocks, they can be valued like stocks. Therefore we can use our traditional disciplines of fundamental, valuation and money flow analysis to make both strategic and tactical decisions in client portfolios.

Low Expense Ratio & Taxes

In addition to being priced like stocks, ETFs have a low expense ratio, which can save you money on fees over time. The average ETF carries an expense ratio of 0.44%, which means the fund will cost you $4.40 in annual fees for every $1,000 you invest.^{^[2]} This lower cost is especially important if you put the money you save back into growing your portfolio. By the way, many ETFs have expense ratios substantially lower than 0.44%. For example, the S&P 500 ETF {symbol SPY} mirrors that index and carries an expense ratio of just 0.10%. I would also note that expense ratios in basic index ETF have been trending lower as the major ETF index providers have been caught in a war for market share by lowering the costs of their funds.

Along with being relatively inexpensive, ETFs are also tax efficient. Most ETFs are better at this than traditional index mutual funds and far outstrip the tax efficiency of most actively managed mutual funds. This is due to the way they are structured. Without getting too technical, ETFs usually have less turnover or taxable events than a traditional index or actively managed mutual fund. The average turnover rate for an ETF is less than 10%3 while the many actively managed funds can turnover more than 100% of their fund during the course of a year. So many transactions and portfolio changes can lead to unwanted tax bills for clients at the end of the year. The structure of ETFs largely solves this problem.^{^[3]}

Diversification

Being tax efficient is a huge benefit of ETFs, but the ability to eliminate single stock risk while at the same time diversifying clients’ portfolios is an even bigger draw to utilize ETFs as an investment vehicle. Over the past 10 years, ETFs have been increasingly used as substitutes for single-stock exposure. Since there are hundreds of ETFs available, I can create specific asset allocations for my clients using ETFs in order to help create a diversified portfolio and mitigate risk.

Transparency

Another advantage of ETFs is transparency. Because they are traded on a daily exchange, ETFs must report their performance and holdings each day. After the financial scandals of the late 2000s, this transparency is increasingly attractive to investors because they are able to see exactly where and how their dollars are being invested. It also enables me to do traditional fundamental and valuation analysis on a known pool of portfolio assets.

Ability to Structure Risk

Speaking of risk, many investors have been wary of jumping back into the stock market since the Great Recession of 2008. ETFs have become my primary investment vehicle for clients who want exposure to the market without the worry of single stock risk

ETFs can provide some stability in unstable markets and there are enormous advantages to ETFs, especially during volatile times. But it is important to note that ETFs are not immune from market declines. If their underlying index declines then they will also lose value by something that mirrors the decline of that underlying index. They are also not a panacea for volatility. Past events and market flash crashes show that ETFs can be violently whipsawed about. However, because ETFs are based on an index we can invest during such periods knowing we are buying a diversified portfolio of assets, backed by the value of the securities in an underlying index and structure that risk by removing single stock exposure from the portfolio.

The history of equities tells us they can be wracked by fraud, can trade to zero due to a catastrophic loss or be rendered obsolete by unforeseen technological change. It is an extremely low probability event that a plain vanilla ETF, especially one with a long trading history and based on a well-established index, will suffer such a catastrophic event causing it to lose all value. I say this is a low probability event because 30 years of investing has taught me there are no guarantees. However, the inherent value of the underlying assets and the unique creation and redemption process of ETFs make this unlikely. Frankly probability suggests the only events that would cause the inherent value of a majority of ETFs to trade to zero would be ones where we think most of us would have more things on our minds then the value of our investment portfolios. Because the underlying assets supporting ETFs have value, we can use our systematic approach to creating portfolios and strategies from this asset class.

How I Can Help

Are you interested in seeing if ETFs are a good fit for your investment portfolio? At Lumen Capital Management, we can help put together a strategic plan to incorporate ETFs into your investment strategy. Call my office at 708.488.0115 or email us at lumencapital@hotmail.com to set-up an appointment today. I look forward to helping diversify your investments with a low-expense, tax efficient investment vehicle, while limiting risk of unexpected market changes.

About Chris

Christopher R. English is a money manager and the founder of Lumen Capital Management, LLC, a Registered Investment Advisory firm. Specializing in investment management and developing customized portfolios that reflect a client’s values and needs, he has nearly three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 708.488.0115 or emailing lumencapital@hotmail.com.