Exchange Traded Funds Vs. The Stock-based Portfolio

The everyday idea of market trading is a flurry of excitement for one who imagines it, conjuring up movie images of the unknown genius who rides a fast wave of brilliant thinking to a fortune. “Playing the market,” i.e. speculating and trading individual stocks on the exchange, captures the public’s imagination. Understandable, for playing the stock market essentially carries the investor away through the thrill of gambling.

Building a portfolio of stock shares can indeed prove fruitful to the clever investor, particularly in boom periods. The gains achieved on the New York Stock Exchange made headline after headline after that market went through the roof with the dot-com explosion in the 1990s. With lots of foresight and a fair share of luck, investment in smaller lesser-known companies (e.g. tiny, embryonic firms like young Amazon.com) can bring stunning returns.

But in stock portfolios, it’s all about the risk. Daily diligence on the investor’s part is necessary. While stock market players live up to the verb “to play,” mutual funds, index funds and ETFs demonstrate the principle of “slow and steady wins the race.”

At the heart of success in ETF investment is the simplicity of what experts report to be the overwhelming factor in success: Asset allocation. Some sources call asset allocation of chief importance and absolutely crucial to success in investment.

The exchange traded fund turns traditional thinking about investment in exchange markets on its head. Those who pick and choose from among the thousands of individual stocks out there are judging based on data from or about individual firms; the consideration given the type of stock is minimal.

The reverse philosophy of ETF investment makes for the most marked difference between these funds and the most traditional of all market investment types: With ETFs, the investor is for all intents and purposes buying a proportion of an entire market and so the ETF investor is freed from the decision of divvying up the portfolio among varying asset classes, not to mention the subsequent innumerable day-to-day choices required of the stock investor.

So if huge returns can be gotten trading stock, what is the importance of asset allocation? This question was addressed in the often cited research undertaken by Brinson Partners, Inc. and spearheaded by CEO Gary P. Brinson in 1986. Examining hundreds of small- and medium-scale investors with positive and negative track records, Brinson and co. demonstrated that investment performance can be determined to a rate of 95% based solely on selection of asset class; in the long-term, went subsequent reasoning, most attention should be paid to an entire industry rather than each publicly-traded company separately.

The importance of the 95% statistic shows how useful the ETF system can be. Choose almost any asset class and, barring a serious market-wide hit, the ETF investment will increase in value. Whereas the pure stock portfolio can contain numerous blocks of shares and therefore numerous decisions to make in initial investment and day-to-day considerations of fluctuation, an ETF investment of the same size requires one single selection that can be researched much more thoroughly.

Economics experts connect the risk inherent in individual stock investment with the amount of competition on the market. In Europe, Tokyo and North America, the stock markets are simply bloated with possibilities. Stock analysis today is so plentiful, mutually contradictory and often beyond the public sphere that the private investor must react quickly and often blindly in periods of high fluctuation.

And there’s a further problem with the 21st century world of too much information: Poring through this data is costly to brokers and money managers; that cost, Mr./Ms. Stock Market Investor, is passed on to you, giving you further expense to cover in potential earnings. Statistics show that the average stock portfolio does not outperform the market in which it is based, and few private investors can chase a winning streak over the long haul. In this game, the house essentially always wins.

When all that is required is selection of asset class, most of the guess work, dependence on consultants and commission fees are eliminated. And if we believe that asset class selection determines results (cf. the Brinson study), the investor in ETFs avoids an entire level of difficulty. Choosing among the 13 accepted primary asset classes in which ETFs are currently available allows thorough examination of markets.

What can be done during times of market skyrocketing? Well, ETFs are often chosen because of their features similar to stock. Trading with ETFs can take place in essentially the same fashion as shares in the stock market, with options to buy on margin, limit order, sell short or use a stop-loss order at the ETF investor’s disposal. ETFs are priced throughout the day and heavy losses can be avoided by the even slightly vigilant.

Believe it or not, brand new exchange traded funds released in 2006 address the exciting issue of getting in on the ground floor of emerging businesses. Why miss out on this year’s Amazon when the First Trust IPOX 100 Index Fund and the IPO Plus Aftermarket Fund are available? These ETFs not only make the IPO a distinct asset class in itself, but they allow ETF trading off major indices.

Though it seems unlikely the American market will see anything resembling the crazy growth of the mid- and late 1990s, fields such as biological engineering, genetic research, pharmaceuticals and the internet still produce overnight successes with resultant incredible returns. Indeed, the new IPO ETF market looks to capitalize on the extreme growth that always exists somewhere in the market. A tiny bit of calculation will show that IPOs in 2004 and 2005 well outperformed the sluggish market and, in theory, usually can.

One trade-off does exist for the would-be IPO exchange traded fund investor, though: The appeal of IPO investment has, since its inception, been all about the first day’s turnover. Traditional IPO investment has allowed the quickest dip in the stock market pool known, with large-scale investors pulling cash they’d invested twenty-four hours earlier on a regular basis. The long-term investment of ETFs may seem to be an automatic contradiction to making money in often fly-by-night IPOs, but IPO exchange traded funds, too, offer most advantages the ETF investor seeks. In the case of any fund based on the IPOX index, investors only start receiving returns on IPO gains seven days after the firm’s entry onto the exchange, staying within the index for 1000 trading days. However, the short-term long-term investment here is also intriguing: Consider, for example, that still-increasing Google shares remain a healthy part of the IPOX 100. And the bottom line shows that the IPOX 100 posted gains of almost 20% higher than those obtained by the IPO Plus Aftermath mutual fund and the Standard&Poor’s 500 index.

If playing the stock market can be likened to roulette (and, at times of economic slowdown, enormous competition and fickle consumers can make it feel so), exchange traded funds are akin to blackjack: Yes, brainpower is necessary, but the odds are quite a bit better.

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