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I'm in my late 30s living in the EU and for some time now, I've put the vast majority of my savings into a number of index ETFs. This is based on the philosophy that trying to beat the market is a game for professionals and fools, so since I'm neither I should just diversify and keep expenses low.

Am I running some risk by restricting myself to ETFs as an investment vehicle? Is there anything I should pay attention to when selecting ETFs, other than the expense ratio and how the underlying index helps me diversifying?

Michael Borgwardt
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4 Answers4

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Shall we consult the oracle?

My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S & P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

Warren Buffett, Berkshire Hathaway Shareholder Letter, 2013

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Am I running some risk by restricting myself to ETFs as an investment vehicle?

Yes there are risks here. First, be aware of what strategy are you using with the ETFs as if you invest in 30 or more of them, you may well wind up with a rather confusing combination of funds. Be sure you know what strategy you have for using ETFs with ideas like asset allocation, rebalancing and diversification as some ETFs may not necessarily be that diverse if one gets into the specialized sector ones for example.

Is there anything I should pay attention to when selecting ETFs, other than the expense ratio and how the underlying index helps me diversifying?

Be aware of the purpose of the ETF as JoeTaxpayer's comment on leveraged ETFs is worth noting. How liquid is the ETF, what is the size of the ETF and be aware of various strategies of how indices can be put together as while among US large-cap indices there may not be that many big shifts, in small-caps and a few other areas there may be differences as companies like Russell will re-constitute their indices twice a year while S & P does a bit more management of their indices.

The liquidity is how many shares trade each day as if the volume is low then you may run into greater gaps between the share price and the underlying Net Asset Value of the shares as the creation/redemption is usually done in blocks of 50,000 shares. The size of the ETF is the market capitalization as I could imagine some of the smaller ETFs eventually being shut down. An example here is Merrill Lynch's HOLDRs product that existed for a while.

The index reconstitution is worth noting for a couple of reasons:

  1. Purity of style. If a small-cap fund could let its winners run, they would then become mid-caps or large-caps and thus you aren't diversifying in reality. Some people may slice and dice things rather finely and thus one may not be aware of what ETF is covering which market segment. Thus, this is more a about how well does the fund handle style drift.

  2. While the same market segment may be covered, there could be different ways to look at this style. For example, there could be ETFs in the small-cap area that deal with the smallest stocks out there compared to others that deal with larger stocks that still make up what could be seen as small-cap stocks by some.

JoeTaxpayer
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JB King
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Michael,

I think that you are giving the professionals too much credit, as they too lose to the index on average. This is math and not an opinion. ETFs are very safe investment vehicles. You should concern yourself with the expense ratio of the ETF and the liquidity of the ETF. In general if you stick to Vanguard ETFs you'll accomplish both goals. If you want to know more about ETFs there is a book written on the subject by Rick Ferri that is excellent.

brett
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One thing you might be missing is that if you want to dollar-cost average, your trading fees could outweigh the management fee difference between index mutual funds and ETFs. However, if you are just purchasing/rebalancing once a year you are probably still saving fees with ETFs. Of course, if you are sufficiently wealthy and don't have to pay trading fees this is a non-issue.

One option that few people take advantage of is to take advantage of DRIPs on your ETFs which could help with cheaper compounding (if you have to pay trading fees) in the long run.

Keep an eye on if any international ETFs are currency hedged. There are differing ideas about if hedging is a good plan. You might have to decide between a hedged and non-hedged version of an ETF.

As all the other responders mentioned, as long as you constuct a long term plan and stick to it you are making a wise decision to use ETFs.

lonestar21
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