Thanks for joining us for the second entry in our HNRE blog series – Financial Tenets. The subject of this entry is Low-Cost ETFs (exchange traded funds). If you missed our first in the series, please go back and check out “Pay Yourself First.”
To follow up on the strategy of paying yourself first and enjoying the returns from compounding, we should discuss where to invest your “secret” stash.
Now, I’m by no means a financial analyst, nor a broker, so please don’t take my advice and use it with any expectations to performance. However, I’m more than happy to share with you how our family has invested our money over many years.
When I first began paying myself first I would invest in individual stocks and mutual funds in an attempt to ride the wave of the highest performers. It took me several years, and too many losses, before I was fully shaken from the dream of riding 20%+ returns year in and year out. In fact, after a lot of analysis I came up with a few guidelines for myself that I still follow to this day when selecting funds and/or ETFs.
Here are my guidelines for selecting ETFs:
- Low turnover
- Broad index
- Low fees
Let’s dive deeper into each of these guidelines.
I mention low turnover first because it’s the least known and understood. I first learned about this criteria when I used to spend a lot of time on the Morningstar website back before ETFs were a thing. Annual turnover is the percentage rate at which a mutual fund or an ETF replaces its investment holdings on an annual basis.
Why is this important to the average investor? Because turnover equals taxes. The higher the turnover in your fund or ETF, the more capital gains distributions you pay taxes on. It’s quite the surprise when you see the tax bill on your investment but the value is unchanged or has even declined. Surprise might not be the right term, frustrating is more accurate.
The higher the turnover %, the higher the taxes you can expect. I like to invest in funds with a turnover of under 10%. Luckily for me, most ETFs have low turnover because they’re tracking an index which changes little over time.
(Note) Here is a hack – if your 401k doesn’t offer ETFs, which many don’t, consider index tracking mutual funds as they’ll typically have lower turnover as well.
Learn more about turnover from Morningstar: Turnover Ratio | Morningstar.com
I like to invest in broad market index funds for 3 reasons:
I want to keep my volatility low. Now, you’re probably saying that broad market ETFs can be volatile – just watch the financial news, right? However, they’re not nearly as volatile as an individual stock. A single bankruptcy or scandal will not tank an entire ETF like it could an individual stock.
I like broad market ETFs is because they cross sectors. To me, trying to pick which sector to invest into is much like timing the market. As I’ve already mentioned, I’ve failed at timing the market in the past and I don’t expect I’d do any better picking sectors, or even regions, accurately.
Therefore I stick with the Dow, S&P, or NASDAQ tracking ETFs.
I don’t have the time or knowledge to beat 80% of active managers. I’m sure you’ve heard a stat like this one in the past, “66% of managers can’t match S&P results” or “86% of active managers failed to beat the market in 2014.” Well, according to Investopedia:
“Over the last 5-year period (large cap managers), 80.8% underperformed the S&P 500. Over the last 10-year period, 79.59% of active managers underperformed.”
So there you have it. I’m certainly not tracking the market on a full-time basis like these managers are and they’re not consistently beating the broad market ETFs. I’ll just stick with the Dow, S&P, or NASDAQ ETFs thank you very much.
I saved this one for last because it is by far the most important criteria for picking an ETF. You can easily pick a mutual fund with an expense ratio of over 1.5%, even 2%. That’s crazy when these managers are underperforming the broad indexes 80% of the time. And even small ¼ point differences in expenses can greatly impact an ETF or mutual fund’s performance. Just check out this table on Investopedia’s site showing the impact of different expense ratios.
The basic point here is that if you aren’t guaranteed a better performance than the index tracking ETFs, then you shouldn’t be paying more than a nominal fee for management. The average ETF expense ratio is 0.44%. That’s a huge savings over other investment options charging much more where only 1 out of 5 options will consistently beat their index.
Are you lucky enough to pick that 1? And willing to pay the extra fees for that privilege? Not me, it’s much simpler to secretly stash my cash in a low fee index tracking ETF. It’s proven successful for our family anyhow.
Be on the lookout for the next tenet in the series – more on Dollar Cost Averaging and Compounding.