Not all ETFs are Created Equal

© (Getty Images)
© (Getty Images)

When investors think about the risk in their 401(k) or other brokerage accounts, they often frame it in terms of volatility. Most often, they are concerned about sharp declines in the U.S. stock market. With memories of the 2008 market plunge fresh in people’s minds, it’s understandable that many view volatility and risk as one and the same.

But that’s not necessarily the best way to think about portfolio risk. In his most recent annual letter to Berkshire Hathaway shareholders, Warren Buffett addressed that topic, writing, “Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”

Buffett was making the point that over the past 50 years, the return of stocks far outpaced the purchasing power of the dollar, which declined over that time. The “riskier” investment in stocks is actually the way to stay ahead of inflation and maintain purchasing power. That’s a key premise behind a carefully crafted retirement investment plan.

Exchange-traded funds provide a window into an understanding of portfolio risk. Historically, ETFs tracked basic market-capitalization-weighted indexes such as the Standard & Poor’s 500 index of large U.S. stocks. On the fixed-income side, a number of ETFs track the Barclays U.S. Aggregate Bond Index (formerly the Lehman Aggregate Bond Index) of investment-grade, dollar-denominated bonds.

A broadly diversified portfolio, constructed with ETFs representing several stock and bond asset classes, has its own distinct risk-and-return profile. For example, a portfolio containing 70 percent stocks has more risk than a portfolio with 40 percent stocks. Stocks are riskier than bonds, because in a bankruptcy, debt holders are repaid before equity holders. Investors demand to be paid more for taking that risk; hence, stocks have higher returns relative to bonds.

With the information at investors’ fingertips today, it’s not particularly difficult to design a portfolio with the right asset mix to achieve an expected return over time, while dampening the volatility of stocks.

But when investors veer into more esoteric ETF products, such as those concentrated in a single sector or that use complex strategies, the risk-and-return trade-off changes.

Ron DeLegge, U.S. News blogger, founder of ETFGuide.com and host of the Index Investing Show, a weekly podcast, says the more specialized, niche ETFs should be considered as noncore parts of a portfolio.

“The core portfolio is the foundation. That’s where the bulk of the assets will be allocated,” says DeLegge, who is based in San Diego. “The core is always broadly diversified and invested across the five major asset classes: stocks, bonds, commodities, real estate and cash.”

DeLegge says in this area of the portfolio, investors should use low-cost ETFs that track broad-market indexes.

“The noncore portion of a portfolio is complementary. This is where you have things that are narrowly focused, concentrated, higher risk, maybe leveraged,” he says.

Individual stocks, he adds, are outside the core because they represent concentrated positions in one very specific asset. Likewise, sector funds, regional funds, hedge funds and actively managed funds are noncore because none track a broad asset class.

Although risk and volatility are not the same, investors are familiar with the nail-biting experience of volatility, even when their portfolio is taking a level of risk appropriate for the desired outcome. Understanding what he or she owns, and why, can help smooth an investor’s ride.

Elisabeth Kashner, a chartered financial analyst and director of ETF research at FactSet in San Francisco, says investors should be realistic in their expectations of niche or esoteric ETFs. “By and large, you’ll find that these products are not magic. Usually, if a fund has greater returns than a comparable vanilla, market-cap-weighted benchmark, it’s because it has taken on more risk to get there. If the returns are lower, it’s generally because the fund has taken less risk,” she says.

“Most of the time, the index and fund construction process has not delivered more return for less risk,” she adds. “You have to be careful. I’m not saying these products are underperforming, I’m saying they are performing in line, that their performance is driven by risk.”

Alex Bryan, an analyst with Morningstar’s manager research team in Chicago, says the category of “strategic beta” – also known as “smart beta” – has been growing rapidly. Strategic beta funds use methods like tracking indexes not constructed using traditional market-capitalization weightings. Strategic beta funds, which do have strict methodologies, differ from most active funds, which rely heavily on stock picking and generally don’t have ironclad investment rules.

Bryan says part of the growth in the category is due to fund companies marketing the products heavily. “There’s been a push on the fund company side. They can charge higher fees for creating products that look different from other people’s, whereas if you are offering vanilla, broad-based exposure, you are competing on cost,” he says.

He cautions investors to understand what they are buying if they decide to put money into an ETF that doesn’t track a broad index. “There are some where the methodology is not transparent. We at Morningstar are more skeptical if you don’t know exactly what’s going on under the hood. You want to know what are the drivers of performance,” he says.

Kashner offers similar advice for retail investors. “There are reasons to go into a complex strategy, but there are usually more compelling reasons to keep it simple,” she says. “Or, if you are going to take something simple and make it more complex, you should understand exactly why you are doing that and what you hope to get out of it. If you don’t understand that, you are probably best off keeping it simple.”

Copyright 2015 U.S. News & World Report

Written by Kate Stalter of U.S. News & World Report

(Source: U.S. News & World Report)

7 Stock-Picking Mistakes Even Savvy Investors Make

© peepo/Getty Images
© peepo/Getty Images

Everybody loves a winner.

That explains why America seems to be obsessed with stories of amazing stock pickers, such as the New Jersey teen wonder who allegedly turned $10,000 into $300,000 by trading penny stocks from his smartphone.

However, even some of the smartest (and luckiest!) investors make mistakes sometimes. Here are seven dumb mistakes to watch out for the next time you’re picking investment options.

1. HAVING NO INVESTMENT GOALS

If you don’t know where you’re going, you’ll never know when you get there.

However deeply people may agree with this statement, there are still those who lack clear investment goals. Your first step in investing is defining these goals.

Here are three examples of good ones:

— In order to avoid the extra cost of private mortgage insurance, you would like to save for a down payment that is at least 20% of a $300,000 apartment in your city within the next 10 years.

— You first child is just born and you would like to have $35,000 available for his or her college tuition by their 18th birthday.

— Planning to retire 33 years from today, you and your spouse calculated you’d need $3,000 every month to cover your expenses during retirement.

Notice the two things that these goals have in common: a specific dollar amount and a target date. These two elements are the starting point for any discussion about investing. They allow you to establish a timeline and select benchmarks to evaluate your performance.

Before you even think about stock picking, establish your investment goals.

2. IGNORING YOUR RISK TOLERANCE

There are two key elements to determining your risk tolerance.

First, there is your time horizon. A rule of thumb is that the longer your time horizon, the riskier your investments may be. Since you don’t need the funds for quite a while, you can better sustain the ups and downs of the market and chase higher returns. On the other hand, if you need the funds a year from now, you’re better off taking more conservative investments.

Second is your available “play money.” A person with a net worth of $1 million is more likely to better stomach the price fluctuations of a $25,000 investment than a person with a net worth of $75,000. Also, don’t forget about potential liquidity issues. The second individual would be in a really tough situation if he were to suddenly need those $25,000 to pay damages from a lawsuit or meet another type of big financial obligation.

Pick investments according to your time horizon and bankroll.

3. SPENDING INSTEAD OF INVESTING

While some people are very eager to start stock picking, others think they can’t even afford it.

Or it could be that those others may be listening to their “lizard brain” a bit too much. The idea of the “lizard brain” refers to the instincts that helped our ancestors to survive back in the stone age. Given scarce resources and the ever-present possibility of death, our ancestors prefered to enjoy things right away instead of waiting.

Old habits die hard. Given the choice of enjoying $500 right now or receiving $3,000 in five years, most of us would chose the first option. However, this is a bad idea.

4. PAYING TOO MUCH IN FEES

This is one of Warren Buffett’s top three investing mistaketo avoid.

While you can’t be 100% sure about the return of your stock picks, you can be 100% sure of how much money you’re paying in management and trade fees. For example, if you were to invest $10,000 in the average actively managed U.S. mutual fund, you would pay $132 in fees. On the other, you would pay just $17 by investing the same $10,000 in the Vanguard Total Stock Market Index, the largest index mutual fund.

5. TRYING TO BEAT THE MARKET

Here’s another reason to choose index mutual funds.

Most actively managed funds fail to achieve returns above their respective benchmark. Only about 20%–35% of fund managers are able to “beat the market.” These are the pros that do this for a living. Are you sure that you can do better than them on your spare time while juggling your job and family life?

Over the long-term, index funds are typically top performers and do better than 65%–75% of actively managed funds. And index funds cost you less than a fund manager, too.

6. BETTING ON A SINGLE STOCK

There are too many stories about people getting filthy rich by putting all their money on Apple stock.

Before you decide to put all your eggs in one basket, consider the performances of these two other past media darlings.

Groupon

Launched in November 2008, Groupon quickly became the leader of the deal-of-the-day movement. Groupon became one of the fastest companies to reach a $1 billion valuation. Heck, Groupon was doing so well that it turned down a $6 billion buyout offer from Google. However, an original investment of $10,000 in Groupon on November 7, 2011 would only be worth about $2,554.66 today.

Enron

It’s hard to believe that Enron was once a media darling. Back in 2001, Enron’s stock was priced at 70 times earnings and 6 times book value. Out of the 22 analysts covering Enron, 19 of them rated the stock a “buy.” The maximum stock price of $90 in August 2000 convinced several people to put all their nest eggs on Enron. A little over two years later, the stock was trading below $1.

The lesson is that history tends to repeat itself, so don’t bet all your money on a single stock.

7. NOT REBALANCING YOUR PORTFOLIO

Last but not least, remember that asset prices vary over time.

Your investment plan sets a target allocation of your monies in different types of investments. For example, you may have 50% in domestic stocks, 30% in foreign stocks, 20% in bonds, and 10% in T-bills.

Let’s imagine that your foreign stock holdings had a nice upward ride for the last five years. So, now they represent 50% of your total investment portfolio’s value. It’s a good idea to rebalance your portfolio to set back your allocation of funds to the target 30% so that you’re not taking more risk than you’re comfortable with.

It’s shocking how simple it can be to avoid these seven investing mistakes. There’s no secret to stock picking — it just requires planning and sticking to that plan. It may not sound exciting, but it’s more likely to make you a profit. And isn’t that why you really invest?

Written by Damian Davila of Money

(Source: Time)