Generally speaking, most people who invest in the market usually do so through mutual funds. Whether it’s an individual trading account or some form of retirement plan, passive investors typically choose a vehicle that allows them to set their money aside without having to worry about it. The only problem is that mutual funds are flawed instruments for maximizing financial performance. While they do provide access to professional money managers and make portfolio management easier for the common investor, they are also the vehicles that most consistently underperform the market and charge high fees.
Recently, new instruments known as exchange-traded funds, or ETFs, have become increasingly popular among investors, both in the retail and institutional crowds. They are similar in many ways to mutual funds, most notably closed-end mutual funds, but are not actively managed, and thus charge significantly lower costs. Overall, ETFs offer the same benefits that passive investors like about mutual funds, but also provide much more of the flexibility that sought by active investors. Therefore, they’re powerful tools that can help maximize the profit potential of any investment strategy.
ETFs Versus Mutual Funds
Let’s consider the issue of expenses first. Assume you have a portfolio of $100,000 invested in a mutual fund that has a yearly expense ratio of 0.6 percent with no front or back loads (which would actually be a relatively cheap mutual fund), that grows at a rate of 8 percent. After 10 years, you have paid $7,243.28 in expenses alone. That equates to almost a full year of performance negated from your portfolio.
However, now consider a similar portfolio of ETFs that is identical, but has an expense ratio of 0.15 percent (an average expense ratio for an ETF). After 10 years, you have only paid $2,172.98 in expenses, which equates to a cost savings of over $5,000.00.
Using ETFs to Replace Mutual Funds
Since mutual funds are fundamentally made up of other financial assets, one can actually create a ‘synthetic’ mutual fund to replicate—or even surpass—the performance by using a basket of ETFs.
The following example should illustrate this nicesly: If we have $10 in a mutual fund that is made up of 60 percent stocks, and 40 percent in fixed income, we can create a synthetic version of the mutual fund by investing $6.00 in a stock ETF, and $4.00 in a fixed income ETF. While simplistic, this example illustrates a powerful concept. Since ETFs are cheaper than mutual funds, we can essentially create a mutual fund that is cheaper just by combining ETFs. As stated above, the cost savings with this strategy could translate to thousands of dollars depending on the size and time horizon of an investor’s portfolio.
Our ETF model has also produced ETF portfolios with better performance than their mutual fund counterparts, so the savings would be even more pronounced.
This process can then be taken a step further. Mutual funds engage in a practice known as Quantitative Equity Portfolio Management, which uses mathematics to find the combination of assets that provides the best tradeoff between return and risk available. While the formulations of this method are beyond the scope of this article (and will be elaborated upon in a future installment), there is no reason why we cannot take advantage of the same methods in our synthetic mutual fund creation.
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