An exchange-traded fund, or ETF, is an investment that trades on a formal exchange, like a stock. Unlike a stock, a share represents an undivided interest in a pool that invests in multiple assets. For instance, the first ETF in the US was created to fully replicate the S&P 500.  As such, it theoretically invested in the 500 stocks that make up that index, and its performance was directly correlated with the performance of the S&P 500.  If the S&P 500 increases 3.8 points on a given day, so does the SPY exchange-traded fund, although the correlation is not perfect.

Advantages of ETFs

The most obvious advantage of an ETF is that, like a traditional mutual fund, it allows for a lot of diversification for a small investment.  That diversification can be relatively narrow, such as the Guggenheim Timber ETF (CUT), which is designed to track the stocks of global timber companies and currently holds 27 securities.  They can also provide broad diversification, as exemplified by the Vanguard Total Bond ETF (BND), which replicates an index that tracks close to 8,000 bonds.  The ETF itself has nearly 5,000 holdings.

Of course, for retail investors, access to that kind of diversification has long been the province of traditional mutual funds.  So what makes ETFs different?

One of the key advantages touted by ETF enthusiasts is the fact that they trade all day long, and thus you can move in and out of positions throughout the day, just like stocks.  That contrasts with traditional mutual funds, which trade only at the end of the day.  The trading advantage also includes other characteristics that distinguish stocks from mutual funds, such as the ability to buy on margin, use limit orders, sell short, etc.

These distinctions are real, and ETFs certainly provide enhanced trading flexibility.  For the record, though, I don't think the ability to trade in this manner is necessarily a positive thing from a behavioral finance perspective.  I will say this: if the bottom falls out of the market, and you suddenly decide that you need liquidity, selling at 10:03 a.m. ahead of additional price erosion is preferable to waiting until the end of the day to redeem your mutual fund shares.  In reality, though, that would probably be a result of poor planning more than anything.

Cost advantages 

The more important advantages, as far as I'm concerned, revolve around cost of ownership. In general, ETFs have lower expense ratios compared to traditional mutual funds, even when a direct counterpart exists. Take the case of Vanguard, a company known for its passive indexing investment products. In numerous cases, Vanguard has launched an ETF equivalent of popular index mutual funds in their lineup.  Vanguard's version of the S&P 500 index fund carries an attractive .17% expense ratio.  The equivalent ETF, with the same holdings and the same investing mission, charges just .06%.

There are never sales loads for retail investors, although you typically pay a brokerage commission to buy and sell ETFs.  However, if you bought the aforementioned ETF through Vanguard, you'd pay zero commission.  Several of the bigger discount brokerages offer a range of free trades for designated ETFs. Of course, even when you do pay a commission it is usually very inexpensive these days.

Tax efficiency of ETFs

Exchange-traded funds are also generally more tax efficient than their traditional mutual fund counterparts.  Because they often employ a passive investing strategy, on average ETFs have much lower turnover than actively managed mutual funds.  Furthermore, in contrast to traditional mutual funds, the structure of ETFs allows them to mitigate capital gains more effectively, which means the actions of other shareholders do not have the same impact as they would with mutual funds.

In the case of traditional mutual funds, purchases and redemptions by some shareholders can cause capital gains tax implications for all shareholders.  This is not the case with smaller ETF shareholders.  If you sell your shares for a loss or a gain, you will be subject to the appropriate tax treatment of that loss or gain. However, you will likely not be subject to the same level of capital gains taxes as would be the case if you owned an identical mutual fund.  Furthermore, when a larger shareholder redeems units of an ETF and capital gains are triggered, they will likely be at a higher cost basis (less taxes) than is the case with a mutual fund.

The technical details behind the tax treatment of ETFs and mutual funds are probably better left to a separate post.  The key takeaway is that ETFs will generally be more tax efficient than even a mutual fund with the same holdings and trading patterns.

ETFs and enhanced transparency

While mutual funds only report their holdings at the end of each quarter, typical, plain-vanilla ETFs generally communicate their holdings on an ongoing basis. Among other things, this sidesteps the potential for window dressing.

Window dressing comes in multiple shapes and sizes, but in brief it entails hiding the holdings of a fund by selling just before a reporting period ends and buying something that looks more attractive.  For instance, let's say a mutual fund maintains large holdings in several stocks that performed poorly over a given reporting period.  Furthermore, one or two of those holdings lose value in a very public way, much like Sears Holdings just dropped about 20% when it reported that it had a poor holiday season and will now close up to 120 stores.  Rather than face the music and defend why he maintained a big position in the underperforming holdings, a fund manager may just sell out of those positions and buy a stock that performed very well over the period in question. Consequenty, it looks like the fund was well-positioned during the quarter, and the manager has a knack for identifying good investments.  Theoretically, money would flow to that fund as a result.  Of course, your overall investment in the fund would not miraculously increase with this sleight of hand.  In fact, a careful observer would be forced to wonder why the fund didn't perform better, given its positioning.

The practice of window dressing is not possible if holdings are being reported on an ongoing basis, as is the case with the average ETF.  To a much greater degree than is the case with mutual funds, ETF investors know what they're getting when they make a purchase.

Important note:  the ETF transparency issue is less black and white than is commonly assumed.  That is probably a topic for a future post, but for today's purposes, the transparency that is relevant here pertains to the simple, plain-vanilla ETF that tracks an index and is meant to be a passive investment.  There is a large and growing universe of more esoteric and leveraged ETFs that play by different rules.  That IS a topic for a future post.

In the paper "The impact of staying invested during market turmoil", Russell Investments presents some data demonstrating the consequences of several different courses of action during the 2008 financial downturn, through the end of 2010.

The data shows what would have happened if a hypothetical investor had a $100,000 portfolio, and had invested 60% of the portfolio in a broad index of stocks and 40% in a broad bond index on October 9, 2007, and then took one of three steps on September 30, 2008.  The initial date - October 9, 2007 - was the height of the market prior to the downturn.  September 30 was about two weeks after the Lehman Brothers bankruptcy, and was a point of inflection that marked the front end of the most significant market drop during the downturn.

It's also worth noting that a 60/40 portfolio is a reasonable representation, but it isn't an optimized portfolio for most investors.

The Courses of Action and Results

Course 1 -  Stay the course and maintain the 60/40 index strategy through the end of 2010.  This would have yielded a portfolio value of $104,502.

Course 2 -  Pull out of the market altogether on September 30, 2008, going to 100% cash, as represented by a short-term Treasury Bill Index.  This was a typical (and understandable) fear-based move that was not at all uncommon during that time period.  Doing so would have allowed the investor to miss the worst of the downturn.  It also would have resulted in a portfolio value of $85,469 on December 31, 2010.

Course 3 -  Pull out of the market altogether on September 30, 2008, and invest 100% in a broader Treasury index.  This is another fear-based, defensive move that probably makes more sense than going to all cash, but likely wasn't quite as common.  In this case, the investor would also have missed the most severe segment of the downturn.  This portfolio would have ended 2010 valued at $94,451.

The Bottom Line 

Clearly, staying the course in this case would have had a significantly more positive impact on continued wealth-building than taking other, more fear-based actions.  The years in question represent a small sample size, but also a very extreme example of the bottom falling out of the market.  Furthermore, investors with a deliberate strategy optimized for their level of risk tolerance generally would have done better than what the paper demonstrates.

Of course, what the paper doesn't show is the mental anguish associated with holding on when the world seems to be caving in around you.  This is especially tough when you have no idea where the market is going at any point in time.  The fact is, nobody knows what the market will do tomorrow, but we do know what it has done over long periods of time.  Hopefully this data will help to provide some context for how to approach the next market downturn.

An oft-cited tenet of investing philosophy that has been passed down over the years is that Dollar Cost Averaging (DCA) is a good way to invest in a risk-managed manner, particularly for beginning investors.

The basic approach is that you invest a consistent amount at regular intervals, which ensures that you buy more shares when prices are low (and fewer shares when they're higher).  You engage in DCA with each 401(k) contribution, and with any systematic investments you make to an IRA, 529 plan or a taxable investment account.

For instance, if you had $8,000 to invest at the beginning of this year, and decided that you simply wanted to invest in an index fund that tracks the S&P 500 Index, you could have chosen the SPDR S&P 500 Exchange-Traded Fund (SPY)*.  You would have then faced the decision of when to invest the money.  Doing so on January 1 would have allowed you to buy at $128.68.  Investing $1,000 on the first day of every month would have given you an average cost of $131.16, because prices trended higher through much of the first half of this year. 

Is it a good idea?

Probably the most logical comparison to make is between DCA and lump sum investing.  In other words, if you don't have a lump sum that you could invest at the beginning of a period, but want to invest on an ongoing basis, your decision to dollar cost average is pretty straightforward.

What if you do have a lump sum that you could invest?  Should you average into the market over time?

While DCA may feel better to a lot of investors, the fact is that it doesn't result in better aggregate returns.  If you had $10,000 ready to invest at most points in history, you'd be statistically better off putting it all in the market rather than averaging in over time.  Why?  Because the market typically goes up.  I know, I know, it doesn't seem like it, especially after watching CNBC the past few weeks.  However, between 1970 and 2010 most sectors within the stock market showed a loss in only 7-9 of the 40 years, depending on the sector.  Since 1926, it's more like 20 years, out of 84.  I don't want to sound too analytical, but the stock market goes up more than it goes down.  It stands to reason that investing a lump sum at the beginning of a period will generally do better than spreading it across a series of investments over a number of years.  Of course, you may not want to break that data out at a cocktail party with somebody who went all-in in May of 2008.

The decision to invest the lump sum is more obvious for the dividend enthusiasts among us.  Waiting to get into the market could mean foregoing dividend payments.  Those dividend payments can be reinvested, and over the long run they will contribute significantly to the overall returns of a stock market investment.

Does it ever make sense?

A Dollar Cost Averaging approach to investing matches up nicely with most savers' ability to invest.  Not many of us have a pile of cash sitting around looking for something to do.  Not to sound like Yogi Berra, but if such a pile exists, and we invest it, it no longer exists.  Systematic investing makes a ton of sense, and that implies that DCA is at work.  The discipline and forced savings that accompany such an approach are key components of building wealth, and in that sense Dollar Cost Averaging makes a ton of sense.

*Not a recommendation to buy a specific security.

If you participate in a 401(k) plan, chances are you've heard of target-date funds.  Perhaps you've even been told that your contributions will default to such a fund if you don't specify otherwise.  In the last few weeks I've worked with employees of at least 4 employers for which this is the case.  All in all, more than 70% of 401(k) plans now offer target-date funds, and for various reasons they are often the default option for new participants in the plans.  Another popular use of these funds is in 529 plans for college savings.

So...what is a target-date fund?

A target-date fund is a mutual fund that invests in multiple asset classes in a way that is designed to be appropriate for a time horizon defined by the fund.  The asset mix changes to become more conservative over time, as the target date gets closer.  This change in asset mix over time is commonly referred to as the glide path.  Because it invests in multiple asset classes, such as various classes of stocks and bonds, and alters the asset allocation over time, the target-date fund is really designed to be a portfolio unto itself.  In practice, such funds will typically invest in several other mutual funds, each of which is dedicated to a specific asset class.

Challenges of target-date funds

Probably the most significant over-riding challenge associated with target-date funds is the fact that many consumers group all such funds together.  I think most tend to understand the difference between a fund targeted at, for instance, retirement in 2015 vs. retirement in 2040, fewer seem to distinguish between the 2040 offering from Vanguard and the 2040 offering from T. Rowe Price or Fidelity.  These funds are not necessarily managed in a similar manner.  Asset allocations will likely differ, and the underlying funds that the target-date funds own will certainly be different.  A recent Government Accountability Office (GAO) report found that the performance of these funds varies widely from family to family.

More specific criticisms include:

Expenses - Target-date funds typically charge fees at the fund level, including a management fee to cover the effort associated with defining the asset mix and selecting underlying funds in which to invest.  Of course, these underlying funds charge fees of their own, which results in the layering of fees.  The underlying funds are often index funds, and the associated fees can be relatively inexpensive.  That's not always the case, though, and it takes some digging to unearth the total cost of investing in target-date funds.

One-size-fits-all approach - The fact that two individuals plan to retire in the same year does not mean that an identical investment approach is warranted.  Among other things, they may be different ages, and may have different levels of risk tolerance.

Investments - The fund family that manages a target-date fund will typically look to invest in funds from within the same family.  For instance, Fidelity will invest in Fidelity-managed funds, the MFS Lifetime funds invest in other MFS-managed funds, etc.  Without trying to indict a specific fund family, there may be an incentive to use less popular and less successful funds within the target-date funds.

Are they good for anything?

I think the best argument in favor of target-date funds is that the better ones serve as a reasonable default option for investors who will not otherwise put forth the effort to select funds in a methodical manner, according to an allocation that makes sense for them.  If they prompt people to save who otherwise wouldn't, regardless of the reasons, they are probably serving a valuable purpose.  Regardless, this is an increasingly broad category of products, and to really ensure that a target-date fund is a reasonable option requires some digging.  

Several Camelback Fund investors emailed me this week about an Op-Ed piece in the Wall Street Journal by Jeremy Siegel and Jeremy Schwartz (link to bios) that reiterates their feelings that Treasury bonds are in a bubble, and suggests that dividend-paying stocks are the answer to a Treasury bond market that they feel is dangerous.

I try to read whatever I can by Jeremy Siegel, and I did see this piece, but I very much appreciate when investors and other interested parties share these kinds of things with me.

It should be noted that one of the primary points of the article is the authors' acknowledgment that a subset of investors has avoided dividend-paying companies because the big banks and related financial companies pretty much all cut their dividends in 2008.  Their share prices also crashed.  With few exceptions, they haven't returned to pre-crash levels.  Siegel and Schwartz don't think financials will have the same impact if we see a repeat performance, as they now make up only 16% of all dividends in the S&P 500, and dividend-paying companies in every other sector have rebounded nicely.  They point out that, aside from financial companies, dividends for other stock sectors actually grew in the period from 2007-2009.  While it felt to many like the stock market was imploding, investors in non-bank dividend-paying companies were able to bide their time and actually see an increase in cash flows if they simply stuck to their strategy.

Some other highlights from the piece:

• Corporations are more profitable than ever, and those that pay dividends are generally better able to pay them than they've been in a long time.  The average payout ratio of less than 30% provides a "huge cushion" for companies to continue paying their dividends even if a double dip recession materializes.  
• The dividend yield for S&P 500 companies is now more than 2%.  That means that simply investing in a decent S&P 500 index fund will provide exposure to capital appreciation as well income that stacks up very nicely against Treasuries.  Of course, a more focused strategy will pay considerably more than that.
• Dividends for S&P 500 companies have grown at a faster pace than inflation over the past 50 years, in periods of low inflation as well as high inflation.  A lot of people are flocking to gold to protect against impending inflation.  (Others don't actually know why they're flocking there, except that it has been going up lately).  In fact, it's hard to say when we're going to see higher broad-based inflation.  Dividends will outpace it if we do, and they'll outpace it if we don't see it any time soon, based on the historical record.
• Dividends in the S&P 500 have grown by 10% over the last 2 years, as corporations are holding record amounts of cash, and many are "rightly" returning some of it to shareholders.  One of the key points that seems to have been forgotten in the recent market turmoil is the fact corporations have been turning in record profits, and those profits have generated record cash hoards.  More and more companies are choosing to return to the old ways by distributing at least some of this cash to its owners.