Why ETFs Are Soaring In Popularity Among Individual Investors

by: Michael Krause

Retail investors have replaced institutional investors as the primary source of new inflows into exchange traded funds. And with all the media hype surrounding ETFs, it’s little wonder. But of all the benefits commonly touted as reasons for the funds’ soaring popularity—including their low fees, tax efficiency, and ability to trade throughout the day—many commentators miss one of the most important reasons of all: ETFs are the perfect asset allocation tool, and asset allocation is the most important decision an investor can make.

A landmark study published in 1986 by Brinson, Hood and Beebower* concluded that even professional money managers were able to add very little value by their selection of individual stocks or attempts at market timing. Rather, the vast majority of variation in returns – 93% in the funds examined by the study – could be explained by asset allocation.

Asset allocation is the process of deciding how much of your portfolio to invest in each asset class, however they are defined. Broad asset classes include stocks, bonds, and cash; as well as commodities, real estate, collectibles, foreign currencies, and some would argue derivatives.

Investment professionals and academics alike work themselves into a tizzy debating the merits, nuances, and implications of the Brinson study. But we know from practical experience that:

  • Professional managers add little value by security selection or market timing, which is why so few are able to consistently outperform their peers (or a benchmark) within the same asset class.
  • Allocation among the various asset classes, however they are defined, is exceedingly important in determining investment performance. That’s no guarantee you’ll get the asset allocation decision right, but that’s where you should focus your effort.

As with everything in the world of investing, it gets more complicated. Broad asset classes can be subdivided in a variety of ways. Stocks are usually broken down by sector, market cap, style or geography (domestic/int’l); bonds are broken down by issuer type, credit quality, and more. And so on for the various asset classes. Academic studies since Brinson have largely reached the same conclusion: however the asset classes are defined, the allocation of funds among them is the most important decision an investor can make, not in picking individual investments within the class.

Increasingly ordinary investors accept those findings. Contrary to the constant admonition from professional money managers that “it’s a stock picker’s market” (imagine that); picking stocks is often a fool’s errand. ETFs allow you to easily target an asset class, with more flexibility and accuracy than either index or actively-managed mutual funds, and often cheaper as well. That is why they are soaring in popularity among small investors.

To illustrate: most investors remember 2001 as a dismal year for stocks. In reality the average stock in the S&P 500 was up that year! But the mega-cap Tech stocks that dominated the index fell precipitously, dragging the index down with it. However, you could have sold short the Technology Sector SPDR (NYSEARCA:XLK) in proportion to its representation in the S&P500, thereby “carving out” the troublesome sector—something you could not have done with any mutual fund.

Again, there’s no guarantee that you would have had the foresight to get out of Tech, but many people did. And for the first time they had a ready-made vehicle to do something about it. With an index mutual fund tracking the S&P500, you would have been forced to go along for the ride in what had effectively become a mega-cap Tech-heavy asset class, whether you wanted to or not.

With an actively managed mutual fund, you would have had to trust that the manager had the foresight to do something about it (many did not), and you could not have known whether or not this was the case until after the fact when fund holdings were reported months later.

Critics will argue that with more than 400 ETFs listed in the U.S. and hundreds more in the offing, something more than just asset classes are being offered—really, how many asset classes can there be? They have a point: some ETFs seem to be more creations of the marketing department that have no discernable economic rationale as an asset class per se. But others represent different flavors of asset allocation, and some of the newer more innovative products are designed to dynamically assist with the constant job of asset allocation.

For example, the PowerShares FTSE-RAFI 1000 (NYSE:PRF) functions like an equity asset allocation tool on auto-pilot. While remaining broadly diversified by market cap, style, and sector, it uses a fundamentally-driven methodology in an attempt to systematically avoid market excess by periodically reallocating assets.

In the first instance (“carving out” Tech from the S&P) the onus of asset allocation is on the individual investor; in the case of PRF it is on the fund, making it more suitable for “set-it-and-forget-it” investors. Either way, the ETFs are tools for implementing an asset allocation strategy.

Of course, there’s no guarantee you’ll always get that strategy decision right—but since it’s the only one that really matters, isn’t that where you should focus your efforts? Increasingly, it looks as if ordinary investors now driving ETF assets agree.

* Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, "Determinants of Portfolio Performance," Financial Analysts Journal, July/August 1986.