Making the Big Switch from Mutual Funds to ETFs

By Murray Coleman

All things must pass. And for me, that means an era of investing through index mutual funds.

It's not that I've become fascinated with some star manager. I'm still an indexing geek. It's just that recent events make it illogical to keep buying higher-priced versions of the same benchmarks I've been investing in up to this point.

While some of the index mutts in my portfolio have dropped in price, almost all of their ETF cousins have gone down even more. In the end, how do you justify paying more for a fund that invests in the same basic index?

Sure, matters such as bid/ask spreads and liquidity need to be considered. But I'm not much of a trader. And most of the ETFs I've chosen are from well-known providers with histories of managing their funds well. The other reassuring piece of the puzzle is that my investing style lends itself to broad-based asset classes.

So, I've stopped resisting and joined the ETF collective. My portfolio's now almost completely invested in ETFs, with the lone holdout coming from a bond index fund that's in the process of being converted. I'm using a no-commission brokerage from a reputable and large financial institution. It's working fairly smoothly and although the number of free trades has a maximum, I don't see myself ever coming close.

The all-ETF portfolio has a total expense ratio of 0.15% per year. It could be less but I'm splurging a little by adding a tad of SPDR S&P International Small Cap (AMEX: GWX). It comes with a hefty expense ratio of 0.60%.

This is a new asset class for me, since small-cap foreign index mutual funds are still a rare and pricey breed. In ETFs, my head's spinning over the choices. Fortunately, after doing some research on past articles on IU, I was able to narrow my list to GWX and iShares MSCI EAFE Small Cap (NYSE: SCZ). I like the latter's more economical ER (0.40%) but prefer GWX's inclusion of some emerging markets.

My portfolio's based on a total stock market ETF. I've tried slice-and-dice to all sorts of extremes. But I prefer to play it more straight down the line. A bit of U.S. small-cap core stock ETF exposure adds enough spice to suit my tastes.

On the stock side, the rest is made up of international ETFs. I tend to appreciate the arguments made by Steven Schoenfeld and others that the MSCI EAFE index is somewhat outdated. So my strategy is to split allocations equally between a European-focused ETF and a Pacific ETF dominated by Japan.

Of course, this leaves me with a big overweight in Asia relative to the EAFE index. While correlations can be tricky to judge over time, I don't think it's a big leap to think that European markets will remain more closely tied to those in the U.S. in coming years. At least, it seems plausible that correlations will stay in a tighter range.

Even if that doesn't happen, it's difficult for me to discount the fact that Japan still has one of the most developed economies in the world. People are going wild over China's future prospects. But that seems like pure speculation at this point. I've heard that one of the country's largest banks just got its second computer recently.

The biggest mistake I've made in the past is to confuse investing with speculating. As a result, part of my allocation is reserved to scratch that itch. So, I'm staying away from single-country ETFs and overplaying some of China's biggest trading partners. (After all, Japan isn't exactly the most stable place to put your money into these days.)

Actually, I do hold some direct exposure to China through a small allocation to a diversified emerging markets stock fund. And GWX owns some China as well.

As far as alternative asset classes, those seem really interesting. But I'll go with good old-fashioned bonds. They're still dirt cheap and quite effective to offset stocks. And again, my main holding is a total market portfolio on the bond side. It falls into the intermediate duration range, but I've got a small allocation to a short-term total bond market ETF as well.

The best performer in my new portfolio this year has been a fund focused on TIPs. I've been told by professionals that too many people over-allocate to these types of bonds. I realize there's always going to be trade-offs for adding different features to plain-vanilla packages. But for someone like me who won't need to touch the money for another 15-20 years, how do you bet against inflation?

The more experience I gain as an investor, the more it seems apparent that the hardest decision usually is to do nothing. But I do reserve the right to make strategic allocation changes as circumstances change and my stomach churns. The tech wreck was hard and I did wind up increasing bond allocations on the margins.

Basically, though, I'm pretty set. That's my strategy in a nutshell. Pretty boring, eh?

It's funny, though. My wife thinks we've got a real cutting-edge portfolio now with all of these brand-spanking-new ETFs. I don't have the heart to tell her they've actually been around for 15 years.

Comments

[amateur]

Take a look at PFK, as a substitute for your TIPS. You get a much higher yield, for the same duration, and the difference is a lot more than Prudential spread would justify.

[kalasend]

Not trying to be picky about words here, but this is pure BS:
"I've heard that one of the country's largest banks just got its second computer recently"

[lawstar]

Surprised to read the author finds bonds "dirt cheap" at the moment, since initiating a position in U.S. bonds with an "intermediate duration" NOW is hardly a way to grow (or even protect wealth) in my mind. My assumption is that the author's "total market portfolio" of bonds is roughly in line with AGG, GVI, or BND. Each of which is about 28% treasuries and agencies.

U.S. goverment issues are, in my mind, outrageously expensive. On a risk-adjusted basis, an investment in treasuries etc. today have very limited upside, regardless how low the Fed. goes.

I see so many problems with the timing of this core bond allocation that I will limit my discussion of the downside to a few remarks. An intermediate duration of 6 to 8 years exposes the already meager yield--paid in U.S. dollars--to the inevitability of rising rates. During this time, an investor will likely realize a negative return, as inflation and a secular devaluation of the dollar, evaporate any nominal return.

As far as the remaining 72% of this portfolio, I am only marginally more constructive. I do concede that some junk bonds are now reasonably priced. But the indexes described have minimal exposure to this debt. For the investors with a long time horizon and desire to hold income-producing investments, the more opportune strategy NOW would be scoop up blue chips that are capable of growing dividends, in addition to exploring carefully selected MLPs, REITs, junk bonds, when fear sells genuinely "cheap" assetts.

I'm aware that my suggestion doesn't address the issue of correlation. But other asset classes and strategies can be employed until U.S. bonds become "cheap" once again.