Enter the traders

TIP was an instant success with large institutional stock traders, who saw that they could now trade an entire index in a flash. The Toronto Stock Exchange got what it wanted — more trading — and the world of ETFs got its start.

TIP has since morphed to track a larger index, the so-called S&P/TSX 60 Index, which — you probably guessed — tracks 60 of Canada’s largest and most liquid companies. The fund also has a different name, the iShares S&P/TSX 60 Index ETF, and it trades (in Canada) under the ticker XIU. It is now managed by BlackRock, Inc., which, upon taking over the iShares lineup of ETFs from Barclays in 2009 (part of a juicy $13.5 billion deal), has come to be the biggest player in ETFs in the world. I introduce you to BlackRock and other ETF suppliers in Chapter 3. (A completely different BlackRock-managed U.S. ETF now uses the ticker TIP, but that fund has nothing to do with the original TIP; the present-day TIP invests in U.S. Treasury Inflation-Protected Securities.)

Moving south of the border

The first ETF didn’t come to the United States for three or so years after its Canadian birth. (Oh, how my public school teachers would cringe!) On January 22, 1993, the Mother of All U.S. ETFs was born on the American Stock Exchange (which, in January 2009 — a big year for mergers and acquisitions — became part of NYSE Euronext). The first U.S.-based ETF was called the S&P Depositary Receipts Trust Series 1, commonly known as the SPDR (or Spider) S&P 500, and it traded (and still does) under the ticker symbol SPY.

The SPDR S&P 500, which tracks the S&P 500 index, an index of the 500 largest U.S. companies, was an instant darling of institutional traders. It has since branched out to become a major holding in the portfolios of many individual and institutional investors — and a favorite of favorites among day-traders.

Goodbye, ridiculously high mutual fund fees

The average mutual fund investor with a $150,000 portfolio filled with actively managed funds will likely spend $945 (0.63 percent) in annual expenses, per the Investment Company Institute and Morningstar. By switching to an ETF portfolio, that investor might incur — if they incur any trading costs at all — perhaps $50 or so to set up the portfolio, and maybe $20 or so a year thereafter. But now the investor’s ongoing annual expenses will be about $270 (0.18 percent). That’s a difference, ladies and gentlemen of the jury, of big bucks. We’re looking at an overall yearly savings of $625, or more if your brokerage has eliminated trading commissions altogether, which many have. Keep in mind that your $625 or more a year will be compounded every year the money is invested.

Loads, those odious fees that some mutual funds charge when you buy or sell their shares, simply don’t exist in the world of ETFs.

Capital gains taxes, the blow that comes on April 15th to many mutual fund holders with taxable accounts, hardly exist. In fact, here’s what my predominately buy-and-hold clients with their taxable money in ETFS have paid in capital gains taxes in the past three years: $0.00.

In Chapter 2, I delve much deeper into both the cost savings and the tax efficiency of ETFs.

Hello, building blocks for a better portfolio

In terms of diversification, my own and my clients’ portfolios include large stocks; small stocks; micro cap stocks; English, French, Swiss, Japanese, and Korean stocks; intermediate-term bonds; short-term bonds; and real estate investment trusts (REITs) — all held in low-cost ETFs. I discuss diversification and how to use ETFs as building blocks for a Class A portfolio, in Parts 2 and 3.

Yes, you could use other investment vehicles, such as mutual funds, to create a well-diversified portfolio. But ETFs — at least most ETFs — make it much easier because they tend to track very specific indexes. They are, by and large, much more “pure” investments than mutual funds. An ETF that bills itself as an investment in, say, small growth stocks is going to give you an investment in small growth stocks, plain and simple. A mutual fund that bills itself as an investment vehicle for small growth stocks may include everything from cash to bonds to shares of Microsoft (no kidding, and I give other examples in the next chapter).

Will you miss the court papers?

While scandals of various sorts — hidden fees, “soft-money” arrangements, after-hours sweetheart deals, and executive kickbacks — have plagued the world of mutual funds and hedge funds, this is the number of ETF scandals that have touched my life or the lives and fortunes of my clients: 0. That’s in good part because the vast majority of ETF managers, forced to follow existing indexes, have very little leeway in their investment choices. Unlike many investment vehicles, ETFs are closely regulated by the U.S. Securities and Exchange Commission. And ETFs trade during the day, in plain view of millions of traders — not after hours, as mutual funds do, which can allow for sweetheart deals when no one is looking.

In Chapter 2, I discuss in greater detail the transparency and cleanliness of ETFs.

Moving from Wall Street to Main Street

In the world of fashion, trendsetters — movie stars or British royals — wander out in public wearing something that most people consider ridiculous, and the next thing you know, everyone is wearing that same item. Investment trends work sort of like fashion trends, but a bit slower. It took from 1993 until, oh, 2001 or so (around the time I bought my first ETF) for this newfangled investment vehicle to really start moving. By about 2003, insiders say, the majority of ETFs were being purchased by individual investors, not institutions or investment professionals.

BlackRock, Inc., which controls more than a third of the U.S. market for ETFs, estimates that approximately 60 percent of all the trading in ETFs is done by individual investors. The other 40 percent consists of institutions and fee-only financial advisors, like me.

Fee-only, by the way, signifies that a financial advisor takes no commissions of any sort. It’s a very confusing term because fee-based is often used to mean the opposite. Check out Chapter 26, where I talk about whether and what kind of financial professional you need to build and manage an ETF portfolio.

Actually, individual investors — especially the buy-and-hold kind of investors — benefit much more from ETFs than do institutional traders. That’s because institutional traders have always enjoyed the benefits of the very best deals on investment vehicles. That hasn’t changed. For example, institutions often pay much less in management fees than do individual investors for shares in the same mutual fund. (Fund companies often refer to institutional class versus investor class shares. All that really means is “wholesale/low price” versus “retail/higher price.”) And institutions almost always bypass nefarious “loads” (high commissions to buy and sell) on mutual funds.

Keeping up with the Vanguards

It may sound like I’m pushing ETFs as not only the best thing since sliced bread but as a replacement for sliced bread. Well, not quite. As much as I like ETFs, good old mutual funds still enjoy their place in the sun. That’s especially true of inexpensive index mutual funds, such as the ones offered by Vanguard, Fidelity, and Schwab. Mutual funds, for example, are clearly the better option when you’re investing in dribs and drabs and don’t want to have to pay for each trade you make…although, starting a couple of years ago, a number of brokerage houses, including Charles Schwab, TD Ameritrade, Vanguard, and Fidelity, started to allow customers to trade ETFs for free.

One of the largest purveyors of ETFs is The Vanguard Group, the very same people who pioneered index mutual funds. In the case of Vanguard, shares in the company’s ETFs are the equivalent of shares in one of the company’s index mutual funds. In other words, they are different share classes of the same fund — the same representation of companies but a different structure and generally slightly lower management fees for the ETFs.

Because Vanguard funds allow for an apples-to-apples comparison of ETFs and index mutual funds, and because the company presumably has no great stake in which you choose, Vanguard may be a good place to turn for objective advice on which investment is better for you. But rest assured — a point that I’ll make again in this book — this ain’t rocket science. For most buy-and-hold investors, ETFs will almost always be the better choice, at least in the long run. I look more closely at the ETFs-versus-mutual-funds question when I design specific portfolios and give actual portfolio examples in Chapter 21.

The proof of the pudding

One study, done in 2010 by Wharton finance professor Robert F. Stambaugh and University of Chicago finance professor Lubos Pastor, looked back over 23 years of data. The conclusion: Actively managed funds have trailed, and will likely continue to trail, their indexed counterparts (whether mutual funds or ETFs) by nearly 1 percent a year. That may not seem like a big deal, but compounded over time, 1 percent a year can be HUGE.

Let’s plug in a few numbers. An initial investment of $100,000 earning, say, 7 percent a year, would be worth $386,968 after 20 years. An initial investment of $100,000 earning 8 percent for 20 years would be worth $466,096. That’s $79,128 extra in your pocket, all things being equal, if you invest in index funds. And if that investment were held in a taxable account, the figure would likely be much higher after you account for taxes. (Taxes on actively managed funds can be considerably higher than those on index funds.)

But wait, what if you carefully pick which actively managed funds to invest in? Good luck! Every year, Standard & Poors issues what they call the SPIVA Scorecard, which shows your odds of beating the indexes by investing in actively managed funds. It’s scary (like, Stephen King–scary) reading. In 2020, 57 percent of active U.S. stock funds lagged the S&P 500 index, and that was an exceptionally good year for active funds. In 2019, 70 percent lagged the indexes; in 2018, 69 percent.

But it is over longer time periods that active funds really show their lack of spine. Again, according to the 2020 SPIVA Scorecard, only 17 percent of actively managed stock funds beat their benchmark indexes over the 10-year period prior to December 31, 2020. Actively managed bond funds tended to do even worse.

Moving to a real-ETF-world example, let’s look at that very first ETF introduced in the United States, the SPDR S&P 500 (SPY). Since its inception in January 1993, that fund has enjoyed an average annual return (as of mid-2021) of 10.4 percent — not bad, considering that it survived several very serious bear markets (2000–2002, 2008–2009, and 2020). Very few actively managed funds can match that record. (You’ll find some performance specifics in the next chapter.)

By the way, SPY, as well as it has performed, has several flaws that make it far from my first choice of ETF for most portfolios; I will divulge these flaws in Chapter 5. But despite its flaws — and I’m certainly not the only investment professional privy to them — SPY remains by far the largest ETF on the market, with total assets of $363 billion. In terms of average number of shares traded daily, nothing even comes close to SPY: 83 million shares.

The major players

In Parts 2, 3, and 4 of this book, I provide details about many of the ETFs on the market. Here, I want to introduce you to just a handful of the biggies. You will likely recognize a few of the names.

In Table 1-1, I list the six largest ETFs based on their assets, as of mid-August 2021.

In Table 1-2, I list the six largest ETFs on the market as of mid-August 2021, as calculated by the number of shares traded.

Twist and shout: Commercialization is tainting a good thing

Innovation is a great thing. Usually. In the world of ETFs, a few big players (BlackRock, Vanguard, State Street Global Advisors) jumped in early when the going was hot. Now, in order to get their share of the pie, a number of new players have entered the fray with some pretty wild ETFs. “Let’s invest in all companies whose CEO is named Fred!” Okay, there’s no Fred portfolio, but the way things are going, it could happen.

I tend to like my ETFs vanilla plain, maybe with a few sprinkles. I like them to follow indexes that make sense. And, above all, I like their expense ratios looooow. When ETFs first hit the market, most had expense ratios, I’d say, in the 0.20–0.40 percent range. Strangely, the growth in the market has created a big divide. The more basic ETFs, such as those that track the S&P 500, have, due to a lot of competition, come down in price. At present, there are dozens upon dozens of ETFs that carry expense ratios of 0.10 percent or less. Heck, all the competition out there has forced down mutual fund fees, as well.

Conversely, many of the newer, more complicated ETFs (and I don’t use “complicated” as a compliment), have expense ratios edging up into the ballpark of what you would pay — even what you would’ve paid several years back — for mutual funds. Approximately 140 ETFs now carry net expense ratios of 1 percent or more; 19 of these have an expense ratio of over 2 percent.

I’m not saying that all ETFs must follow traditional indexes. The ETF format allows for more variety than that. (Actually, when I think about it, some of the traditional indexes, like the Dow, are darn dumb. I explain why in Chapter 3.) But the ETF industry has lost some of its integrity over the past few years with higher expenses and some awfully silly investment schemes.

The rest of this book will help you to sidestep the greed and the silliness — to take only the best parts of ETF investing and put them to their best use.