This podcast episode and article answers the following questions:
- Who is Alex Bryan?
- What is an ETF?
- Why you should own an ETF instead of a mutual fund?
- Ask The Investors: How much accounting should I know before picking individual stocks?
Who is Alex Bryan?
Alex Bryan is an analyst covering passive strategies on Morningstar’s manager research team. He is a top authority in ETFs and is on the Investor’s Podcast to educate the audience about what situations might be beneficial for their portfolio.
What is an ETF?
ETF is an abbreviation for Exchange-Traded-Fund. Imagine a bundle of 100 or even 1000 stocks, bonds, or a combination that you buy in tiny pieces. ETFs are passively managed funds, and simply buy and sell stock based on their capitalization ranking. For example, if an ETF is tracking the S&P 500, the index will automatically own the 500 best companies in the United States. So, when company 501 moves into the 500th spot and replaces the more superior company, the index will automatically conduct the switch for you.
ETFs are traded very close to the net asset value as they are comprised of securities that are traded on the exchange. Most ETFs are very transparent and simply contain listed securities that the investor could buy himself. However an ETF makes the process a lot simpler by omitting multiple trades, commissions, and time spent adjusting the portfolio. There are several advantages for many investors, especially beginners, while considering ETFs. The first is that you spread your risk over multiple securities. While it erodes the option to achieve vast superior market returns, it happily limits portfolio variance – which most people like. For the novice investor, ETFs are a cheap and easy way to expose themselves to the stock market risk and returns and research isn’t intense or required like individual stock picks.
Another of Alex’s favorites is Schwab Fundamental International Large Company Index ETF (Ticker: FNDF). With an expense ratio of 0.32%, it is a bit more expensive than the previous; however, it still remains as one of the cheapest international index funds. The fund is characterized by being cheap on superior numbers that are retained by the operating cash flow, adjusted sales, and dividends plus buybacks compared to the price. Essentially it’s a value strategy aimed to beat the market when the numbers rebalance.
Why own an ETF instead of a mutual fund?
Another popular investment form is the mutual funds. Similar to an ETF, the investor has the advantage of a highly diversified portfolio. Contrary to ETFs that are passively managed, mutual funds are actively managed, which means that the portfolio manager holds stocks for a shorter period of time while buying and selling securities, thus “optimizing” returns for the investor. Perhaps this argument is one of the reasons for the popularity of mutual funds. Just like you hire someone to clean your house or fix your garage, wouldn’t it be great to have someone to constantly monitor and trade in the stock market for you? Well, surprisingly it’s not. Mutual funds perform worse than ETFs.
Remember the expense ratios of 0.07% and 0.32% for owning one of Alex’s favorite ETF? It isn’t uncommon to charge between 2-3% in total annual fees for mutual funds. So is the money well spent? In Tony Robbins Book: 7 Steps to financial freedom, Robbins’ says that 96% of mutual funds underperform the market. Perhaps what is even worse is that 49% of fund managers do not even have $1 in their own fund. That doesn’t add up.
The very structure of an ETF is better than the typical mutual fund for the investor. When an investor purchases an ETF, the trade is performed on an exchange with another investor. This can be done without incurring tax losses because the portfolio manager doesn’t need to sell underlying securities to raise cash. Contrarily, if you as an investor want to sell your shares in the mutual fund, the fund might need to sell securities to raise cash. The sale is a taxable action that is offset in the total performance of the mutual fund, hence a lower return to the investor. Another problem with the structure of mutual funds is that they are vulnerable when the market drops as investors take out their money and are forced to sell securities, and this pushes the prices further down. Just when the fund manager needs the capital to buy undervalued stock picks, the investors in the fund strip the money away from the manager. This timing issues handicaps the fund managers.
Alex Bryan provides even more reasons why the structure of mutual funds makes it hard to compete with a passively managed ETF. The first is that the active management is a zero sum game before fees. For someone to win, another person must lose. Think of the concept of zero sum game like this: the market yields 10%. For a mutual fund to achieve 11% returns, another fund must only yield 9%. Before receiving the fees in aggregate, they get market returns which you could have gotten by simply buying a low cost ETF (10% return). After fees, say 2%, the mutual funds would now only yield 9% and 7% respectively or an average return of 8%. Further, a structural cost disadvantage for actively managed mutual funds is that it needs to pay commission for the multiple trades, marketing of the fund, and the management of multiple client accounts. I think you can quickly see how everything is adding up (not to mention the taxes fund managers have to pay).
If you want to get a deeper insight into ETFs and why they might be the way to go for your portfolio, rather than mutual funds, Alex Bryan’s article of, The default portfolio, is a highly recommended read.
Stig also created a course about how to invest in ETFs. You can see a short promo video below, and learn more about the course here.
Ask the Investors: How much accounting should I know before picking stocks?
Just like you need to speak and understand another language if you are in a foreign country, you need to understand accounting when picking stocks; otherwise you are incurring a lot of risk. Say that a business records a sale. Do you know what happens to the three most important financial statements: the income statement, the balance sheet, and the cash flow statement? Most stock investors don’t. The issue is this: while reading financial statements is one thing, understanding how they interact with each other is even more complex. If you don’t understand how the three financial statements interact with each other, we would argue that you should mitigate this risk by avoiding individual stock picks and focus on index funds. Perhaps the best resource to understand how financial statements interact with each other is the book: Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports. Additionally, Preston and Stig wrote the Warren Buffett Accounting Book to teach investors how financial statements work together. If you understand accounting, you also know how key ratios are calculated, and perhaps more importantly how they can also be manipulated. Happy reading!