5 reasons I love ETF’s

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As I’ve stated before, I use ETF’s (Exchange Traded Funds) to construct the majority of our client portfolios. I started using ETF’s in the early 2000’s and have never looked back.

Since then, many different companies have brought 100’s of new ETF’s to the marketplace.

These days, there is no shortage of ETF’s to choose from… you can build a wonderfully diversified portfolio, using ETF’s of different sizes, styles, asset classes– from international ETF’s to a specific emerging marketplace (i.e. Brazil, Russia, South Korea, etc.)

So without further ado here’s 5 reasons I love ETF’s:

1. ETF’s trade like stocks - the primary difference between an ETF and a mutual fund is how the investor buys and sells his or her shares. ETF’s trade on different exchanges (AMEX, NYSE, Nasdaq) hence the name “exchange traded”, where as, mutual funds are purchased through a fund family and have to be sold back to the same fund family.

You have the flexibility to buy shares of an ETF at any point during market hours; mutual funds prices are set once a day, after the market closes. So with ETF’s you have greater liquidity, flexibility and tax efficiency because they trade like market securities. You can pick up 100 shares of (DIA) just as easily as you can 100 shares of (AAPL)

2. Instant portfolio diversification - a clients US equity portfolio may be made up of 4 ETF’s, each focusing on a different area of the market (i.e. large cap growth, large cap value, small cap growth, small cap value).

A client’s fixed income portfolio may be made up of 2 ETF’s (one made up of government bonds, the other US corporate bonds). The client’s account statement will list 6 positions ONLY, and you can consider this client to be be fairly well diversified.

3. Tax efficiency - ETF’s are far better at shielding investors from capital gains taxes, when compared to mutual funds. When you buy and sell an ETF, whatever gain or loss you incur is yours. This probably sounds simple enough, but it’s not always the case with mutual funds.

With mutual funds, you are one of many investors whose assets are pooled together. As such, you may be subject to paying a portion of someone else’s capital gains, from way before you got involved with the fund.

4. Low expenses - ETF’s are passive investments. There is no active management involved (although there are newer ETF’s challenging that idea) and trading costs are kept low. There are little, to no costs, associated with hiring staff and marketing something that is designed to follow an index.

On average, ETF’s have a noticeable expense ratio advantage over the typical passive and actively managed mutual funds, simply because of the lower overhead.

5. Covered call writing ability- this last category is something that I’ve incorporated selectively into my business and isn’t something you’ll find on most lists. Because ETF’s trade on exchanges, many ETF’s have the same option writing privileges of exchange traded securities.

This may warrant some more explaining at a future date, due to the complexity of the topic, but lets see if I can give you the gist of it here. For the most part, you can generate additional income (which acts much like an artificially created dividend) by writing cover calls versus the underlying ETF position. This is not possible with a portfolio of diversified mutual funds.

Let look at an example of when this may make sense for a client:

The effectiveness of ETF’s

As I’ve stated many times before, the basis for my business is a client’s financial plan. After meeting with the client and going over a newly minted plan, we have a good idea of the type of investment returns needed in order to achieve our goals.

For example, if a plan comes back and lets us know we need an annualized return of 7.2% from our investments (to keep us on track with our goals) here’s how we could approach it.

Well, using our underlying ETF investments, I’ll look to write a covered call (for a future date) anywhere between 8-12% above the current price of the ETF. For this privilege, the marketplace may be willing to give us an additional (artificial dividend) of 1-2%.

In a perfect world, if the ETF is up 8% at years end, we’ll receive the 8% growth and the 2% call income, giving us a total return of 10% exceeding our stated goal.

Please remember I use this strategy selectively, as not every client is willing to cap their potential return. (Writing a covered call caps the client’s return for the option time-frame, but when put in the perspective of the financial planning goals, this is not a bad thing.)

In Conclusion

From simple diversification to total portfolio construction, the modularity of ETFs serves you efficiently and cost-effectively. Now I just listed 5 things I love about ETF’s, and there are numerous other ancillary benefits; I just wanted to touch on some of the more important points. Ok… here’s one last quickie benefit:

I had a client that had 50 different equity positions in his retirement account. We consolidated them down into 6 ETF’s. He no longer receives 20 page monthly account statements and 50+ different annual reports. He can now make heads or tails of his statement and is relieved to have saved a few trees along the way…

Tags: Capital Gains Taxes, covered call writing, ETF, Mutual Funds, Passive Investing