I have had a few people suggest doing a column on ETFs'; wow: not very exciting and certainly not as much fun as my three-part series on budgeting, but hey, this is an informal newsletter and we do take requests. 

ETF's are relatively new to the investing world-I remember-it must've been around 2001 or 2 when Jack Bowman (a living legend in the State Police) asked me one day, "Hey Marty, What is a Spider?"  I thought, Jack surely knows the 8-legged variety-so I knew he must've meant the newly designed and highly promoted SPDR ETFs-short for Standard and Poor's Depositary Receipt/Exchange Traded Funds.  That was my first recollection of any conversation about ETFs-most of the people in my circle of friends at the time could care less what an ETF was.  However, perhaps due their catchy nicknames like Spiders which tracks the S&P 500 companies or Diamonds which uses DJIA companies, news organizations and financial talk-shows bring them up incessantly.

 
Well, first of all, I don't think they are that big of a deal-nice, but not as nice as the intermittent windshield wiper.  In some aspects ETFs work like index-mutual funds in that the ETF contains a number of different investments in a basket of Depository Receipts and the underlying value is ultimately reflected in a share price.  During the trading day you can trade them like individual stocks-but you get the diversification of many positions with one trade.  ETFs do not have their net asset values calculated each day, as do typical mutual funds, but rather their prices may fluctuate throughout the day based on the rate of demand on the open market. 

 
I think what has everyone pumped up about ETF's are that there are so many to choose from; almost any asset class is covered.  IShares[i] for example has ETF's covering the simple S&P 500 to Belgium, to Brazil, to even Turkey.  You find a tradable market in the world and someone probably has an ETF to cover it.  So if you think Brazil is in a good position to benefit from the current economic situation you can purchase an ETF that tracks the Brazilian market index and in about 20 seconds you Brazil's market in the portfolio.    

Also, ETFs have very low internal management costs (expense ratios) that are lower than those of an average mutual fund, and they are usually more tax-efficient than most mutual funds.  Additionally, shareholders can often invest as little or as much as they desire.  However, an ETF cannot be redeemed by a shareholder: rather, it can be sold only on the stock market.    

Now just because ETFs have low expenses doesn't mean they have great returns.  They should have the returns of the underlying asset class index.  Period!  They shouldn't beat the asset index, and they shouldn't trail the index-if their returns don't mirror the index then they don't really have a good representation of the index in their portfolio.  A down side to exchange-traded funds is the commission fee, which is generally not associated with a mutual fund.  Commissions are involved because ETFs are traded like stocks, rather than like mutual funds. 

 
ETFs provide opportunities to buy an index-and by the end of May of this year there were 683 ETF's[ii] covering a crazy number of indexes-it's just the small matter of finding the right one at the right time. 

      
Disclosure:  Exchange-traded funds and mutual funds are sold only by prospectus.  Please read and carefully consider the investment objectives, risks, charges and expenses before investing.  This and other information is contained in the prospectus which can be obtained from your financial professional and should be read carefully before investing.

 

Bond to Stock Allocation: 

"We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds."

"These copybook maxims have always been easy to enunciate and always difficult to follow-because they go against that very human nature which produces that excesses of bull and bear markets.  It  is almost a contradiction in terms to suggest as a feasible policy for the average stockowner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline.  It is because the average man operates, and apparently must operate, in opposite fashion that we have had the great advances and collapses of the past; and this writer believes-we are likely to have them in the future." (p.89)

   
I think in a nutshell BG is saying--for reasons that must be inherent in the DNA of man--we are unable to stick to the buy-low sell-high strategy of portfolio asset allocation.  (Graham only uses two asset classes-stocks and bonds-but it's the same theory.)  This is why we make it a fundamental rule in our investment strategy to rebalance regularly to the original allocations when one asset class gets too far ahead of itself.  If we leave it up to how we feel we will not be able to get the timing right.

 
We rebalance in almost all our portfolios when the deviation from the target gets 4% out of range-some managers do it automatically, and sometimes we do it by just selling out of the highflyers when we need to take withdrawals.  This institutionalizes selling high, and buying low.