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Are ETFs a Good Investment? Reasons to Invest in ETFs

I am the author of the book, 'Building Wealth Made Simple.' My journey in personal finance began when my Father showed Dave Ramsey's books.

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Are ETFs Good Investments?

Are ETFs good investments? Are there good reasons to invests in ETFs? The answer to both of these questions are, "Yes!" There are a multitude of investing strategies, and as someone who has been regularly investing in the market since around the time of the 2008 recession, ETFs have, over time, become my favorite investment vehicles.

ETFs (exchange traded funds) are funds that invest in a basket of stocks or other investment vehicles (such as bonds). In a previous article, I argued that, in general, investing in ETFs is a superior investment strategy to stock picking. The fact is, in almost every scenario, investing in ETFs makes sense as opposed to any other investing strategy.

Instant Diversification

Like mutual funds and index funds, with ETFs, you are buying a fund that invests in a basket of stocks or other investment vehicles. This allows for instant diversification of your portfolio. We don't know what the market will do tomorrow, but if our portfolio is diversified, we can avoid those sudden 20% drops that individual stocks experience due to a bad quarterly earnings report or bad press. ETFs tend to move up and down more steadily than individual stocks do. A lot of people don't like volatility so this more steady approach to investing will allow many people to sleep at night.

Not all ETFs are diversified. Typically, if an ETF is not diversified, it will say something such as, "This fund is not diversified," in its description. So, if you care about diversification, read those ETF descriptions! ETFs, properly selected, will help you follow the old adage, "Don't put all of your eggs in one basket!"

Smart Beta ETFs

Smart beta ETFs are funds that follow a rules-based system. The concept of smart beta ETFs rely heavily on something called Modern Portfolio Theory which was coined by Harry Markowitz in a 1952 essay.1 These ETFs operate based on a set of rules. The rules may vary from ETF to ETF. For example, some EFTs may follow a simple rules based system such as investing in the 50 highest dividend payers in the S & P 500 index. Others are more intricate and may focus on certain qualities such as low volatility, dividend growth, profitability, revenue growth, debt levels, etc.

The rules that a smart beta ETF may follow vary widely. There are some that focus on low volatility. Two examples that have a focus on that are ETFs such as the O'Shares FTSE U.S. Quality Dividend ETF (OUSA) and the Invesco S&P 500® High Dividend Low Volatility ETF (SPHD). Others may seek companies that are undervalued, and some look for companies that are growing rapidly.

As an investor, you can read these ETFs' prospectuses and see if you agree with their investing strategy. If you agree, you can decide to invest in that ETF. On the other hand, if you don't agree with an ETFs investment strategy, you can look for another ETF that suits your preferences.

ETFs Are More Tax Efficient Than Actively Managed Funds

Actively managed mutual funds tend to be more expensive than index funds and ETFs. If you buy an ETF that is a smart beta ETF, it is like having a fund manager without paying the premium that typically comes with having a person manage the fund. After all, computers don't work for a salary.

ETFs also tend to be more tax efficient than actively managed mutual funds because they tend to change holdings less frequently than fund managers do. Fund managers are under a lot of pressure, and because of this, they are often buying and selling assets in order to position their fund to perform well.

ETFs vs. Fund Managers

Your ETF either simply tracks an index or it will follow a set of rules. The latter type of ETF does not panic sell, and it is not under pressure to meet a quota. Unlike fund managers, ETFs have computers that manage them and they feel no anxiety or pressure. Thus, ETFs do not make impulsive and unpredictable decisions like a fund manager may. For example, I remember in fall of 2018, a fund manager on Fox News Business said a recession was coming. Because he thought a recession was coming, he put a lot of the mutual funds' money into Campbell's Soup. Well, that was in late 2018, but in 2019, the S & P 500 index returned north of 30%. Because the fund manager was fearful of a recession that never came in 2019, he missed out on a large opportunity for his investors.

As venture capitalist and shark Kevin O'Leery has said, "Don't cry for money. It doesn't cry for you." Your ETF will behave in the exact same way regardless of whether the market is up or down. It will coldly and callously stick to its set of rules no matter what economic conditions are. Thus, if you like an ETFs rule set, you can count on the ETF carrying out those rules 100% of the time. And, if you don't like how the ETF is performing, you can sell it--unlike a fund manager, there will be no drama or hurt feelings.

To be fair, there are some fund managers that do very well, but most of them do not out perform the market, and if a fund manager doesn't outperform the market, why pay extra for one when you can have an ETF that either tracks an index or has a goal-oriented rule set?

Broad Market Opportunities

Stock pickers sometimes talk about undervalued stocks. ETF investors can take advantage of a similar opportunity. ETFs tend to track an index or invest in multiple companies in designated markets based on a set of rules. If you see a market that you think is priced lower than it should be, you can pick an ETF that will invest in that market, and, you can pick an ETF that has a ruleset that makes decisions that are in compliance with your investment preferences.

For example, some investors think the US market is currently overvalued, and some investors think there are good opportunities in foreign markets overseas. If you agree that the US market is overvalued, you can pick an ETF that invests in a different market such the emerging markets or the more developed European markets.

ETFs not only invest in stocks, they can also invest in bonds and other investment vehicle. ETFs have grown in popularity, and now there are ETFs for every market you can think of.

ETFs Are Less Stressful Than Stocks

Investing in ETFs is effortless. You don't have to crunch numbers, you can buy them and they will go to work for you immediately. If you'd like, you can watch an ETFs price over time and if you see that is near its lowest price or below its average price, you can buy the ETF at a discount.

If an investment vehicle is no longer in an index that your ETF tracks or if the investment becomes ineligible in accordance to the ETFs rule set, the ETF will automatically adjust its holdings so it stays in compliance with its set of rules. You don't have to worry about making adjustments because the ETF will take care of necessary changes for you.

If you invest in individual stocks and you want to stay up to date on their status, you have to keep up with the company's news, listen to conference calls, look at the balance sheet, look at the income statement, etc. With ETFs, you don't have to worry about any of this because an ETF will stay within the rules that you agreed to when you bought it. For example, if you have an ETF that focuses on companies that are growing revenue and one of the company's revenue falls, your ETF will automatically sell that investment.

Regardless of whether you are working, enjoy your hobbies, or spending time with family, your ETFs are taking care of business for you. If you want to be invested in companies that are growing and you hear about a company that has had a terrible quarterly earnings report, you can rest assured that if that company is in your ETF, your ETF will sell it for you. With ETFs, there won't be any panic calling to sell your stock while you are in the middle of that fishing trip.

ETFs Tend to Outperform Stock Picking

ETFs track indices or they follow a set of rules. Thus, not every ETF will out perform the market, but the vast majority of fund managers and stock pickers don't outperform the market either, and, if you want to do at least as well as the market, you can buy an ETF that simply tracks a market index such as the S & P 500.

In fact, billionaires such as Warren Buffett recommend ETFs for most people as opposed to stock picking. Statistically, less than 1% of investors (including fund managers), out perform the market over a five year period.

Conclusion

Although there can be legitimate reasons to stock pick, by and large, ETFs are a superior investment vehicles to individual stocks. You can buy an ETF that simply tracks an index, or, you can buy a smart beta ETF that adheres to a specific rule set. In most cases, smart beta ETFs will have a slightly higher management fee than ETFs that simply track an index. Thus, both types of ETFs carry different advantages.

Given the ease of diversifying with ETFs, their very consistent behavior, the low cost associated with ETF investing, and the lower stress that comes with having a computer manage your investments for you, ETFs are a great investment for any investor.

Footnotes

1. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1952.tb01525.x

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2020 Jason L Petersen