Why Buy an ETF?
It’s become an excepted fact amongst business reporters that the best investments to buy are ETFs, otherwise known as Exchange Traded Funds. What is an ETF and why are so many journalists convinced that you should buy them? Well an ETF is a fancy way to describe an investment that looks very similar too, (but isn’t quite) a stock market index. Unlike mutual funds, the ETF is bought and sold like a stock, but mirrors the performance of an index of your choosing, and by extension all the companies that make up that index. In that respect it shares the (supposedly) best aspects of both stocks and mutual funds. It is traded quickly and is quite inexpensive compared to a traditional fund, but unlike a stock is widely diversified and so should have reduced risk compared to a single company.
In the aftermath of 2008, many journalists that cover the investment portion of the news have touted ETFs as a better investment than traditional mutual funds, citing underperformance against respective benchmarks and the significant discount on trading costs for holding ETFs. ETFs represent a “passive investment”, meaning they don’t try to out perform their mirrored indexes, instead you get all of the ups, and all of the downs of the market. This message of lower fees and comparable performance has had some resonance on investors, and questions about ETFs are some of the most frequent I receive, however while I am not opposed to ETFs I am very hesitant about giving them a blanket endorsement.
That’s because I don’t know anybody who is happy with 100% risk. In the great wisdom of investing the investor should stay focused on “long term” returns and ignore short term fluctuations in the market. But investors are people, and people (this may shock you) are not cold calculating machines. They live each day as it comes and fret over negative news, get too excited about positive news and are generally greedy when they shouldn’t be. In short, people aren’t naturally good investors and being encouraged to buy an investment like an ETF exclusively on cost alone opens up all kinds of other problems for people who find that the market makes them nervous, or may be closing in on retirement. The passive nature of an ETF may be right for some people, but that decision will rarely depend solely on the cost of the product.
The hype for ETFs is therefore more comparable to buying a car exclusively on price based on the argument that all cars function the same way. But depending on your needs there may be multiple aspects you want to consider: size, safety, speed, etc. Investments are similar, with different products offering different benefits its important not to let greed set all of your investment designs. Investing is typically about retirement, not about maximizing every last dollar the market can offer. Reaching retirement is about balancing those investor needs with their wants, and frequently providing less downside at the expense of some of the performance is preferable to the full volatility of the financial markets.