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August-29-12

Do Passive ETFs Benefit Individual Investors?

The awareness and proliferation of exchange traded funds (ETFs) provides retail investors with portfolio management tools that were rare even ten years ago. This has resulted in a move towards do-it-yourself investing using these tools - all major banks now offer discount brokerage platforms so individuals can buy and sell as they wish. And because ETFs trade on the stock market, they can be bought and sold more readily than mutual funds which trade only at the end of each day.

The benefits of this approach to investing include diversification and cost saving. By using an ETF, a basket of securities is purchased in one trade – there is no need for single security selection. And when compared to traditional retail mutual funds, which include compensation for an advisor, ETFs are much less costly since no advisor compensation is included.

But does the use of ETFs result in better performance by individual investors? A study, entitled “Passive Aggressive: Index-Linked Securities and Individual Investors[1], studied data from one of the largest brokerages in Germany. The data covers a period from August 2005 to March 2010. The results supported enhanced performance on the basis of investors being prevented from making wrong stock picks. However, users “are employing these easy-to-trade index-linked securities to make factor bets, and they are betting wrong, especially on the momentum factor... the good effects of better security selection is offset by the bad effects of worse factor selection and factor timing.”[2]

It seems that individual investors, while convinced that single stock selection is a risk factor that can be overcome through diversification, now have cost-effective tools that allow them to try to time the market. Once again, they become their own worst enemy, believing it is possible to improve performance by market-timing.

While all investors are different, and many have the discipline and knowledge to be effective “do-it-yourselfers”, many are not. For those in the latter category, an advisor who works with clients to identify goals, develops a plan to meet those goals, constructs portfolios in accordance with those goals and the client’s risk tolerance, implements using low-cost ETFs or mutual funds, rebalances, pays attention to tax efficiency and helps the client stick to the plan can be well worth the fees charged.

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[1] Bhattacharya , Utpal, Hackethal, Andreas, Kaesler, Simon, Loos, Benjamin and Meyer, Steffen, Passive Aggressive: Index-Linked Securities and Individual Investors (June 29, 2012). Available at SSRN: http://ssrn.com/abstract=2022442 or http://dx.doi.org/10.2139/ssrn.2022442

[2] Ibid, p.6

 

By: Kathleen Clough | 0 comments