Investors Daily Edge Friday, July 31, 2009
The New Era of ETFs - Independent, Informed & International
By Jon Herring
Over the last 40 years, the way individuals invest has evolved in five stages or eras, with each stage of the evolution marked by its own set of tools and preferences. Each era has also been marked by progressively greater benefits, but also many drawbacks and disadvantages.
However, I believe the era of investing we are in today offers the greatest opportunities and advantages that individual investors have ever had access to. That means your ability to profit, while taking on less risk, is greater today than ever before. Let me show you what I mean.
The following are what I refer to as the five "eras" of individual investing, along with some of the benefits and drawbacks for each one:
Individual Investing 1.0 - Mutual Funds
Mutual funds began to gain prominence in the 1970s and really took off in the 80s and 90s. The primary advantage of mutual funds is that they can mitigate risk through wide diversification - something that used to be very difficult for individual investors to accomplish with a small portfolio. There are also a wide range of styles, managers and sector-specific funds to choose from.
But there are MANY disadvantages to mutual funds as well. They can only be bought and sold at the end of the day. Most managers under-perform their targets. The fees can be expensive.
You can be hit with capital gains taxes, due to sales of securities inside the fund (even if you don't sell your shares). And mutual funds generally only work in a bull market (although today there are many more choices than there were 20 years ago).
In 2008, with no bull market in place, investors lost almost $3.7 trillion in mutual funds, according to the mutual fund industry's own Investment Company Institute.
Investing 2.0 - Investing with a Broker
In the 1980s and 90s the number of individual stock market accounts exploded. And at that time, the only way to trade was through a broker. There are many very good brokers out there.
But there are many more who have no idea what they're doing. Others push the products and stocks their firms want them to push (often with conflicts of interest attached).
Brokers also have a strong bias towards buying stocks and keeping you in the market. Not too many brokers would tell their clients, "I expect this bear market to be a ripper. What do you think about liquidating and sitting on cash for a year or two?"
Investing 3.0 - Online Investing
Since the late 90s we have seen a massive shift away from broker-assisted trades to online investing where the investors executes his own buys and sells. This has fostered an era of lower costs and much greater convenience. But it has been offset by much greater risk.
Millions of investors took charge of their own accounts. And many of them were not qualified in the least to do so. With dollar signs in their eyes and an itchy trigger finger on the mouse, they approached the management of their life savings as it if were a video game.
They chased internet stock tips. They 'dabbled' in options and day trading. And they bought when exuberance was high and sold when despair was in the air - exactly the opposite of what an experienced investor would do.
Investing 4.0 - Hedge Funds
The 2000s ushered in the era of hedge funds. And there are many advantages to hedge funds. They offered coverage of markets and access to investment classes that were formerly completely out of reach for most investors. And when hedge funds do well, they can do REALLY well.
But they are also very exclusive and exclusionary. They are not transparent, so you have little idea where your money invested at any given time. And they are expensive, with most funds taking 2% of assets under management, plus 20% of the gains. But the biggest drawback to this fee structure wasn't the cost, it was the "heads I win, tails you lose" nature of the relationship. Funds that are structured this way have strong incentives to jack up the risk to boost the gains. But if their bets go wrong... it's your money that gets flushed.
Investing 5.0 - Exchange Traded Funds
This decade has also ushered in the era of Exchange Traded Funds (ETFs). When used properly, ETFs can offer you all the advantage of what has come before, but with almost none of the drawbacks.
ETFs have truly levelled the playing field for individual investors, allowing us to accomplish things that only the largest institutional investors could do just a few years ago. Learn how to use the wide world of ETFs in your portfolio and you can invest with greater safety, lower costs, more diversification and higher profits than ever before.
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