Ten New Year’s Resolutions For ETF Investors

by on January 2, 2012 | ETFs Mentioned:

For most investors, 2011 was a frustrating year; after some strong early gains seemingly pointed to a continuation of the recovery that took root in 2010, the appearance of some major obstacles sent many major indexes back towards negative territory. The impressive late December rally closed the year on a high note, but there is no doubt room for improvement in 2012 as many attempt to return their portfolios to pre-recession valuations.

The continued innovation and growth in the ETF industry in 2011 has given investors more tools in the toolkit than ever before, and it has made easier to maintain portfolios of all degrees of sophistication using only exchange-traded products. For those looking to take more control over their portfolios in the new year, we highlight ten tips that can enhance your ETF experience and help you get the most out of the robust lineup of exchange-traded products [sign up for a free 7-day trial of ETFdb Pro to get access to more than 30 all-ETF model portfolios]:

1. Diversify Fixed Income Exposure

As the last several years have demonstrated, fixed income exposure can be an incredibly important component of any portfolio. Beyond the ability to generate meaningful cash flows, the ability to smooth out periods of volatility in stock markets has some obvious appeal. So it is perhaps a bit perplexing that most bond portfolios are woefully non-diversified across geographies and issuers; the “home country bias” remains intact in the portfolios of many U.S.-based investors [see Better-Than-AGG Total Bond Market ETFdb Portfolio].

Fortunately, there are now a number of ETFs that allow investors to achieve exposure to international bond markets, many of which offer attractive yields and potentially lower risk than U.S. fixed income securities. Broad-based products such as BWX and various emerging markets bond ETFs have been around for a while now, but recent innovation has delivered targeted exposure that can allow investors to zero in on markets such as Australia, Canada, and even China.

For investors looking to beef up current returns and diversify their fixed income exposure away from dollar-denominated securities, there are a number of relatively new ETFs that can be extremely effective.

2. Scrub Your Expenses

The last year has seen several ETF issuers take steps to further enhance the cost appeal of their products; expense ratios continue to go down, and the number of ETFs in the “single digit basis point club” continues to grow. That can be a very positive development for investors–if they’re savvy enough to take advantage of the opportunities to maximize cost efficiency. Not all ETFs are created equal in terms of costs, and often times the gap between very similar products can be significant. Take the time to evaluate the cost efficiency of ETFs in your portfolio relative to their peer group (the “expenses” tab on the ETFdb Category pages can be used to make that process simple); you might be able to shave a few points off your management fees [see Low Volatility ETFs Attract Big Inflows].

Advice on how to minimize ETF expenses could go on for pages, but here’s a relatively quick (and hopefully effective) summary. If you own any of the following ETFs, there’s an opportunity to achieve identical exposure at a lower price point:

  • S&P 500 ETFs (SPY, IVV)
  • iShares MSCI Emerging Markets Index Fund (EEM)
  • Gold SPDR (GLD)
  • Total Bond Market ETFs (AGG, BND, LAG)
  • MSCI EAFE Index Fund (EFA)
The handful of names mentioned above have aggregates assets well in excess of $200 billion, so there’s a pretty good chance some of them have made their way into your clients’ portfolios [see list of cheapest ETFs].

3. Add Some Alternatives (Or At Least Explore)

The majority of ETF assets are in products covering the two “traditional” asset classes of stocks and bonds. But the ETF universe is by no means limited to these securities; in fact, ETFs covering alternative asset classes have become increasingly popular in recent years as investors have sought out new tools capable of both enhancing returns and reducing volatility.

There are a number of different strategies under the “alternatives” umbrella that run across a wide risk spectrum. Volatility ETPs, for example, are prone to huge swings in value in short periods of time, while long/short products and real return ETFs can be expected to be generally stable. Alternatives aren’t for everybody, but when used correctly they can be valuable additions to traditional stock-and-bond portfolios. Achieving access to these strategies through the ETF wrapper allows for relatively low costs and near complete transparency, two characteristics that can be quite valuable:

4. Stop Paying Commissions

The ETF industry has grown so quickly in large part because of the big expense differentials relative to actively-managed mutual funds. But issuers haven’t been resting on their laurels; instead, they have taken some aggressive steps to further enhance the cost efficiency of an already cheap vehicle.

There are currently more than 200 ETFs available commission free on a number of different platforms, covering a wide range of issuers and asset classes. So if you’re still paying $10 every time you want to make a trade, there could be a relatively easy way for you to reduce the costs associated with managing your portfolio. Depending on the size of your portfolio and the frequency with which you trade, the impact on the “all in” expense ratio could be significant.

TD Ameritrade has the most complete roster of commission free ETFs, including all the major “building blocks” of a long-term portfolio as well as some more precise ETPs. E*TRADE also has a rather robust commission free platform, while Vanguard and Charles Schwab offer their complete lineups of ETFs commission free in brokerage accounts with the companies.

5. ETFs To Replace Your Advisor

One of the more impressive innovations in the past year has been ETFs that offer cheap, hands-free access to popular investment strategies or factors. Among the hundreds of ETFs that debuted in 2011 are funds implementing contrarian strategies, GARP and low P/E methodologies, and screens for factors such as high beta and low volatility. These techniques are, of course, nothing new. But they have never before come in the ETF wrapper, a combination that can result in tax and efficiencies and full transparency [see 25 Things Every Financial Advisor Should Know About ETFs].

There are now ETFs that perform the tasks that investors have historically relied on expensive managers and advisers to perform; issuers including iShares, Russell, and PowerShares have effectively democratized yet another segment of the investing landscape.

6. Embrace The “Forgotten” Asset Classes

Every portfolio, no matter how carefully constructed, will have a few holes in it–asset classes that are excluded. Sometimes, this is done by design; explicitly excluding a corner of the investable universe can be an effective way to generate excess returns relative to a benchmark. More often, however, these “holes” come as a result of an oversight in the asset allocation process.

Building a balanced, comprehensive portfolios with ETFs is a relatively easy process–a big reason why ETFs have become so popular. It’s also easy to overlook a number of asset classes when using only a handful of ETFs [try our Free ETF Screener]. Fortunately, for those looking to achieve more complete coverage there are additional products that can be used to tap into potentially lucrative corners of the market that are often overlooked:

  • Canadian Stocks: Because Canada isn’t included in the EAFE region, this resource rich economy is often excluded. ETFs such as CNDA and EWC can be effective remedies.
  • International Small Cap Stocks: The most popular international equity ETFs, such as EEM, VWO, and EFA, are dominated by large cap stocks. Rounding out exposure to small caps with funds such as EWX or SCZ–or any of the numerous country-specific products–can enhance a portfolio’s risk/return profile.
  • Preferred Stock: This hybrid asset class often doesn’t make it into portfolios, which can be a major oversight. Preferred stock has the potential to deliver some juicy distributions without excessive risk, a combination that many investors no doubt find appealing. ETFs such as PFF and IPFF cover the global preferred stocks market.
  • Floating Rate Debt: Most bond ETFs consists exclusively of fixed rate debt–which can lead to some undesirable outcomes if interest rates rise. The various floating rate bond ETFs on the market can be used to smooth volatility within bond allocations.
  • MLPs: This unique segment of the domestic energy market doesn’t generally receive a big weighting in long-term portfolios. That’s too bad given the impressive yields and stability that comes from MLPs (there are currently nine different MLP ETPs).

7. Explore Alternative Weightings

ETFs have perhaps helped to further entrench market capitalization weighting as the dominant methodology, as the bulk of equity ETF assets are in cap-weighted funds. But ETFs have also made alternatives more readily available; the exchange-traded universe now consists of a number of products linked to indexes backed by methodologies that include equal-weighting, revenue-weighting, dividend-weighting, and RAFI-weighting [see our RAFI ETFdb Portfolio].

There is no universally superior weighting methodology; different approaches result in different biases, and each have their unique pros and cons. But the impact on performance can be much more significant than many investors likely expect, meaning that there is the opportunity to generate some additional returns by employing some of these methodologies in your portfolio [see For ETF Investors, The Details Matter].

8. Revisit ETNs

Most investors are aware of the differences between ETFs and ETNs–specifically, that the latter refers to debt instruments that exposure investors to the credit risk of the issuing institution. Because of this feature, there has always been a perhaps undeserved anxiety among some investors over using ETFs in their portfolios. While the credit risk component of ETNs should never be ignored, that characteristic should also not lead to the exclusion of this vehicle from any type of portfolios.

In addition to the drawbacks of ETNs, there are some potential advantages that can enhance the overall investment experience and lead to additional cost savings and tax efficiencies in certain asset classes. For example, commodity ETNs not only help to eliminate trading commissions, but may lead to lower tax obligations relative to ETFs [see When ETNs Are Better Than ETFs].

9. Boost Your Yield

With interest rates at record lows and many companies hoarding cash in order to protect themselves in the event of additional market volatility, generating a decent yield can be a tough task. Fortunately, there are a number of ETFs that specifically target high-yielding asset classes. While these potential returns are of course not without risk, they might be worth a closer look for those looking to beef up the current returns generated because their portfolios [see Dividend ETF Investing: Four Critical Factors To Consider].

There are dozens of exchange-traded funds that can be useful for enhancing the yield on a portfolio, meaning that investors have opportunities to improve their cash flows through vehicles that boast tax efficiency, transparency, and intraday liquidity:

10. Use The Free ETF Resources At Your Fingertips

With more than 300 new products hitting the market in 2011, the ETF universe now offers more breadth and depth than ever before. Navigating through the nearly 1,400 ETPs to find the products consistent with your investment thesis can be challenging and frustrating. Fortunately, there are a number of free analytical resources available at ETFdb.com that are designed to make the ETF landscape more manageable and make your investing experience more successful. These free ETF tools include:

  • ETFdb Category and ETFdb Types pages, now with enhanced ETF Analytics that allow for comparison of expenses, returns, dividends, and concentration.
  • ETF Screener, which allows investors to filter the ETF universe by dozens of different fields (now including investment factors and strategies)
Disclosure: No positions at time of writing.