Why Index ETFs are Ideal Investment Vehicles?


Hitting the big 5-Oh recently, I decided to verify my retirement investment strategies and goals. While I am maintaining and/or fortifying my positions in solid companies I understand – companies like Apple and Verizon, I am now officially halfway through the 3rd quarter of the earning game. As a result, I can no longer speculate on individual stocks.

Continuing from last week’s post, index funds and ETFs are front and center in a lot of what I’ve been reading lately. As I said, I have some single stocks. But I’m learning more about index ETFs and sector ETFs. They have many advantages.

So what is an index fund?

An index fund is a low-cost (i.e., low expense ratio) mutual fund designed to match either a specific market index or a particular market sector. For example, VFINX (Vanguard 500 Index Fund) is a mutual fund that mirrors the S&P 500 and boasts a super-low 0.04% expense ratio.

Actually, index funds were created by Vanguard’s legendary founder Jack Bogle. In fact, Vanguard is the world’s largest supplier of mutual funds and the second largest supplier of ETFs (behind BlackRock’s iShares).

Then what’s an exchange-traded fund?

Exchange-traded funds, usually called ETFs, are like index funds, except they are traded on the stock markets. The main benefit is lower barrier to entry.

Many mutual funds can require as much as $3000 to invest in a fund. But with ETFs, you only have to have enough to buy a single share. And if you have a Vanguard IRA, you can trade ETFs with no transaction fees inside the IRA.

In addition, the expense ratios of ETFs are low like mutual index funds. In fact, Vanguard has an ETF analog to the VFINX fund with the symbol VOO. Its expense ratio is the same 0.04%.

Why are the expense ratios so much lower?

The reason the expense ratios are lower on index funds and ETFs is that they do not require active management.

Actively managed funds can cost as much as 2%, even in lean years! That means that a significant portion of your earnings can be eaten by the costs associated by active trading. But with index funds and ETFs, that high cost is avoided.

Depending on how far back you look, about 80% of actively managed mutual funds do not even beat the market. But index funds and ETFs allow you to cheaply match the market.

How is this related to asset allocation?

Last week, I wrote about three popular asset allocation formulas from Dave Ramsey (what I use for catch-up), David Swensen, and Ray Dalio. With index funds and ETFs, maintaining asset allocation targets is easier.

For example, let’s say an investor wants to maintain David Swensen’s recommendation of 30% invested in U.S. equities. When the market is up, the investor sells his U.S. Equities ETF (say, VOO) and augments another asset category to maintain his desired asset allocations.

When the market goes down, he may have to increase the U.S. Equities position by shifting more assets into the category from other categories. This ensures that you are buying low and selling high.

Revisiting asset allocation should take place at least once a year. If you geek out on this stuff like me, you could do it once a quarter. Whatever you decide, select a system you understand and believe you can maintain. Then stick to it through thick and thin.

Mark

Hey, there. I'm Mark... I teach statistics and personal finance to high school and college students. I'm also a Ramsey Solutions Master Financial Coach. I create content about financial education... things like: budgeting, investing, and eliminating consumer debt.

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