My Boca Experience – Inside ETF Conference 2010

I was recently privileged to be on a panel at the Inside ETF Conference in Boca Raton, FL last week.  The event was a great success with over 800 attendees, and was broadcasted live by CNBC.  My panel covered how we use ETFs in our practice and how we explain them to our clients.  Matt Hougan of ETFR Newsletter and Indexuniverse.com sent me these questions to help me prepare for the event.  I thought I would share them with you.

What is your strategy and why do you use ETFs?

Matt, there are three ways to invest.  You can buy a stock, buy a mutual fund, or invest directly into indexes (ETFs).  The easiest way for me to explain this is if you purchased Coke stock and the evil people at Pepsi poisoned the Coke syrup, causing people around the world to die from Coke, your investment would be worth 0!  This is called company risk.  While everyone one tells you about their Google-type investment success story, many fail to mention the Enron type losses.  The next way to invest would be through a mutual fund.  While there are certainly some outstanding fund managers out there, the industry as a whole has had a hard time keeping up with the indexes over long periods of time.  If you hired a fund manager to pick your next cola investments, you are beting on his or her ability to avoid the Coke scenario I just mentioned.  A less expensive, more transparent, more liquid, and better diversified choice is investing directly into the index using an Exchange Traded Fund.  This is like buying all the cola companies out there, which greatly reduces your company and manager risk.  Our advisory fee plus the .25% cost of the ETF portfolio is over 1% cheaper than where you are today.  In real world terms, Wiser Wealth will purchases ETFs like the SPY that actually purchases all the companies in the S&P 500.  The same applies to TIPs, corporate bonds, small cap international, emerging market bonds, and stocks.

Wiser builds portfolios using mostly ETFs like the ones I just described to access various types of indexes around the world.  Our core investing philosophy is to maintain a diversified portfolio, keep cost low, and always invest for the long term.  We consider ourselves passive indexers with a buy and hold strategy.  However, each year we review our models to see if there is a need for rebalancing.  While our overall strategy is to buy and hold long term healthy assets classes, we essentially rebuild our 4 main models each summer.  While most of the indexes and allocations remains intact, this forces us to look to see if there is access to new ETFs/indexes/asset classes that will help us achieve a portfolio’s objective.  We build our portfolios in two ways.  Our aggressive model strives to achieve the maximum amount of gain for the least amount of risk.  All other models, such as conservative through moderate, strive to achieve the maximum amount of gain for a given amount of risk.  Here are some examples……………. Let’s compare the cost and performance of these models to where you are now.

What are the risks of ETFs that you’re not telling me about? What could go wrong?

The ETFs that we trade in are large, proven investments that have been around for a long time.  There are ETFs that use leverage or investing formulas that are not very clear.  These ETFs have additional risks.  We do use a commodity ETN that gives you the returns of a commodity index; however, you do not actually own any commodities.  What you own is a promise to pay the index’s returns.  Should the provider go out of business, you could lose your investment in that ETN.  We monitor the financial health of the issuer in this case.  For example, when Lehman began having issues, we looked closely at the health of Barclays.

Why not use index mutual funds?

Wiser uses a complete indexing approach.  We do not seek out actively managed mutual funds, as they generally are more expensive than indexing.  We do not believe that timing the market has proven successful.  There are index mutual funds that work for individual investors, but at our custodian, trading an ETF costs half as much as trading an index mutual fund.  Index mutual funds do have some tax disadvantages compared to ETFs and, for the individual investor, index mutual funds are more expensive.

I’ve heard commodity ETFs don’t actually deliver the spot returns you expect.  Why is that?

The way commodities get represented in commodity indexes and inside ETFs are typically through rolling futures contracts.  Returns from these contracts come from the change in the expected future price of the commodity; this price is very different from the actual price of the commodity that can be bought today, which is the spot price.

Many investors were surprised this year when the oil fund they thought was tracking oil prices was actually tracking the expected future price of oil.

Why should I pay an advisor to manage a passive investment strategy?  Can’t I do it myself?

For many investors, asset allocation is built on feeling rather than using standard deviation, the Sharpe ratio, and other types of risk measuring tools.  Will you rebalance your portfolio on your own?  Will you be able to understand economic events and how to adjust the portfolio accordingly?  Do you ever have tax questions or estate planning questions?  Our AUM fee covers not just portfolio management, but also tax and estate planning.  These are the questions that I would ask a do-it-yourself investor.  You have to take the emotion out of investing.  Many individuals have a hard time doing this, which is why at my firm, we manage by committee.

If you really want to invest on your own through a company like Vanguard, you do have the option to hire us by the hour.  However, it is usually cheaper to become a full service cleint.

How do you ensure you get good trade executions?

Most trades at Wiser Wealth are done through batch trades.  Batch trades allows us to pull all the investors’ trades together.  We then set limit prices on the ETF buys and sells.  Our limit prices are based on the NAV of the ETF at that moment of trading.  A simple way to get the real time NAV is through Yahoo finance.  Just add ^iv to most ETF symbols.  A Bloomberg terminal is the other way to get NAV.

What about currency?

We do not invest in currency as an asset class, but some of our indexes, like IGOV and EFA, have benefited from a falling dollar.  Last summer, we added TIPS to the portfolio while they were cheap, as no one was talking about inflation.  Currency ETFs are trading on currency futures, not actually buying the foreign currency.  This has additional risk in an abnormal market.  Long term investing in currency is not somehting that we see as healthy at this time.

I read about all the blowups in the leveraged ETFs.  How do I know who to trust?  Would you use leverage ETFs in your account?  What’s wrong with them anyway?

There is nothing wrong with leveraged ETFs IF you understand them.  We do not use leveraged ETFs.

I just don’t want my portfolio to go down 50%.  What can you do to help me?

For all our models other than the aggressive model, a loss of that magnitude is virtually impossible.  However, if losses are not an option, we can employ an option strategy on the S&P 500 to add income and create short term insurance on a portion of the portfolio.

Should I buy an ETN?

Yes, but carefully and probably only for commodity exposure.

I’ve read that you can only buy ETFs with $100 million in assets.  Is that true?

That is a good point, but there are 250 ETFs with less than $20 million in assets.  You can buy them, but if not traded carefully, you may end up purchasing at a premium.  Only one of our ETFs, IGOV, approaches that asset level, with $134M in assets.  We noticed when we added IGOV during our last rebalance that it took much longer to purchase at our limit price near the NAV vs. the quick trade at market.  The performance has been just fine, it just took a few extra hours to move the trade through.  Should it have taken longer, we would have simply called the TD Ameritrade trading desk to call the exchange to get the trade processed.

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