"The ETF Book" -- A GEM

[Taylor Larimore]

HI Bogleheads:

I have just finished reading Rick Ferri's, "The ETF Book." With amazing research, Rick provides an in-depth look at the many kinds of ETFs and how to use them effectively. These are a few of his insightful passages:

"Exchange-traded funds (ETFs) are a revolutionary investment product that is taking Wall Street and Main Street by storm."

"How securities are selected for an index and how the securities are weighted in an index has a profound effect on the risk and return characteristics of the index."

"The key ingredients that are critical to the success of any portfolio management strategy is to have a belief, establish a plan based on that belief, implement the plan, and stick to it."

"A successful active strategy does not need to achieve higher returns than the markets if the strategy achieves substantially lower risks than the market."

"The first mutual fund originated in the Netherlands at the same time the United States was fighting for its independence from Great Britain."

"The premiums and discounts in price that occur in closed-end funds is a major disadvantage of that structure."

"1928 saw the launch of the Wellington Fund, which was the first mutual fund to include both stocks and bonds."

"The largest one-day decline occurred on December 12, 1914, when the DJIA fell 24 percent."

"No other mutual fund (except Vanguard) has launched an ETF share class in an existing index fund."

"Having an ETF share class helps increase the tax efficiency of Vanguard open-end share classes."

"There are many exchange traded structures approved by the SEC. Each has different operations, regulatory issues, fees, and taxes."

"If you plan on making a single, large, lump-sum investment, then paying one commission to buy ETF shares makes sense. -- But if you are like most people and invest regular sums of money, you may actually spend more on commissions than you would save on ETF management fees and taxes."

"Hope over reason is the way active management is marketed to the public."

"SEC approval of actively managed equity ETFs will unleash a new wave of products."

"Thre are two types of indexes: market indexes and custom indexes. A market index is a measurement tool. A custom index is an investment strategy."

"The CFA Institute is an organization of more than 80,000 investment analysts who lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence."

"It is prudent to dig deep into the indexing methodology so that you can make an informed investment decision about the ETFs you are interested in."

"There are four methods of capitalization weighting used by index providers: full cap, free-float, constraigned, and liquidity."

"The traditional view of an index as being a passively selected and capitalization weighted basket of securities that represents a market is no longer valid."

"Rules for index construction have stretched from the simple and elegant to the complex and cumbersome."

"The important matter for ETF investors is how the index is managed and the characteristics of the index."

"Realize that stock price has nothing to do with a company's market capitalization."

"The Dow Jones Industrial Average is not used in academic studies or in economic analysis. -- It is an outdated and antiquated indicator."

"The mutual fund industry is widely known for chasing investment performance, and ETF companies are no exception."

"One way to capture fixed income exposure in your portfolio is to invest in a bond ETF that follows a broad bond market index."

"Commodities truly are a trading vehicle, not a long-term investment vehicle."

"An educated investment professional should be able to explain the differeneces between ETF types and styles, including the advantages and disadvantages of the indexes they follow."

"It is very difficult to beat the market. Few people can do it consistently enough to achieve the long-term returns needed to justify the time and expense."

"Beating the market is not just achieving a higher return. -- Risk adjusted returns are a more sophisticated approach to measuring the performance of a portfolio or fund."

"To be a successful passive investor, you need to have an unwavering belief that the strategy will work in the long-term."

"Passive investors do not attempt to time markets by forecasting economic changes or charting prices."

"Passive investors understand how difficult it is to beat the markets, and that few people actually accomplish that feat during their lifetime."

"The most important long-term decision you will make in a buy-and-hold strategy is the long-term mix between stock and bond index funds." That decision will explain a majority of portfolio risk and return over the long term."

"It is very difficult to find major asset classes that have consistently negative or low correlation with one another and are expected to deliver returns higher than the rate of inflation."

"The correlation between asset classes change, sometimes frequently and suddenly."

"During a time of crisis, the correlation between major asset classes increase, for example, global stocks."

"Building a portfolio of buy-and-hold investment in the real world requires more common sense than it does quantitative number crunching."

"If an investor wants to take more risk and explore other options, a core and explore strategy is a good compromise between passive and active management."

"If you create a core and explore portfolio, the more exploring you do, the higher the cost goes with no guarantee of higher returns."

"One 40-year-old may think that allocating 65% to stocks is aggressive while the next 40-year-old thinks allocating 80% to stocks is conservative. Only you can decide whether an allocation is too conservative or aggressive for your tastes."

"Market index portfolios are a good place to start the process of designing a mix of funds that is right for you."

"The key component for starting to accumulate wealth is savings consistency. Ideally, a young person will start a savings plan at the same time he lands his first job."

"A new investor does not know their personal tolerance for financial risk. -- Early savers should probably limit their equity allocation to 80% of their long-term investments."

"Using life cycle investing as the backbone of a lifelong investment plan provides structure and continuity to a portfolio."

"A large number of investors have the undying belief that one day they will eventually find an active method that consistently generates superior results. That is ironic since the scorecard between the active strategies and passive strategies clearly favors passive methods. It is very difficult to outperform market indexes."

"There is an old saying on Wall Street. 'The stock market has forecast ten out of the last four recessions.'"

"It is rare to find one major academic mind that believes technical patterns in stock prices reveal future price trends."

"If you decide to go the active route, be prepared to be wrong frequently, humbled regularly, and rewarded occasionally."

"ETFs are versatile. The can be optioned, shorted, hedged, and bundled into other securities."

"By creating a tax-efficient portfolio, you will pay less in taxes, which automatically increases your wealth."

"Developing and managing a nontaxable portfoliio is easier than a taxable portfolio because taxes do not get in the way of decision making."

"It is a good idea to rebalance at least annually, especially if the markets have been particularly volatile."

"If done successfully, tax loss harvesting will increase an investor's after-tax returns."

"Choosing a person or persons to take over your finances is something to do far in advance."

"There are many methods for predicting market returns, and none will be exact."

"It is not an easy task to predict inflation."

"Do not automatically reinvest dividend income (in taxable accounts). Let the income flow into your cash account."

"If you are too busy, too uninterested, too confused, or not able to keep up with your porfolio, then hiring an adviser makes sense. -- I suggest contacting the Vanguard Group and asking for a free copy of 'How to Select a Financial Advisor.'"

"Diehards.org is used by like-minded investors who are interested in keeping costs low. Not all participants are interested in ETFs, but many are knowledgeable about the subject and can pass along the names of other people who are more knowledgeable. I personally participate on the site and am available to answer questions about indexes, ETFs, and low-cost portfolio management."

Thank you Rick Ferri!

The link below is to more great excerpts in our "Collection of Investment Gems":

http://www.diehards.org/forum/viewtopic.php?t=881

Best wishes.
Taylor

[baw703916]

Hi Taylor,

Thanks for the quotes from the book!

I'm curious if you have formed any opinions on ETFs after having read the book. I know Mr. Bogle has made some statements critical of ETFs, particularly that a lot of them are narrowly focused, and that investors may be tempted to trade them too frequently (both valid points, IMO, although I don't see ETFs as being inherently bad things, if selected and used properly). I'm curious what thoughts on ETFs you took away from the book.

Best wishes,
Brad

[mephistophles]

Thank you for posting those investment gems from Rick. I do have a question though. I thought buying Vanguard's S&P 500 Index and Total Stock Market Index were about as simple and effective a way of investing in U.S. equities as possible. This seems to have become more complicated with the ETF's invested in these same indexes! Some of Rick's ideas also seem to suggest that the above mentioned indexes might differ, not only in cost but in structure.

The reason I mention this is that I will be investing a lump sum amount of money in one of the two indexes, above, with Vanguard in a few months. This will be in a taxable account and will be a one time purchase. Vanguard's ETF's "seem" to be a no brainer due to their lower expense ratio. Am I missing something here? Are there other factors I should consider?

Regards,
ole meph

[peter71]

hi ole meph,

perhaps it's been critiqued here before, but i've personally found vanguard's own ETF vs. mutual fund comparison tool pretty helpful here:

https://personal.vanguard.com/us/faces/ ... sp?etfId=0

all best,
pete

[mas]

The reason I mention this is that I will be investing a lump sum amount of money in one of the two indexes, above, with Vanguard in a few months. This will be in a taxable account and will be a one time purchase. Vanguard's ETF's "seem" to be a no brainer due to their lower expense ratio. Am I missing something here? Are there other factors I should consider?

If this lump is > $100K, then you can qualify for admiral shares. The total stock market admiral and ETF shares have identical .07% expense ratios, making the fund a clear winner - no transaction costs and easier purchase/sale.

[mephistophles]

Pete and Mas,
Thanks for the help. Guess most of the stuff I need to know is right here on the Vanguard site. I pretty much set up all my investments over five years ago and have made few changes since. Now that I am making some changes due to my increasing age, decreasing risk tolerance and desire to create more simplicity than my present slice and cie portfolio has I need to study and bone up on a number of areas.
Thanks again,
ole meph

[risharinga]

Thank you Taylor for a great summary.

"Do not automatically reinvest dividend income (in taxable accounts). Let the income flow into your cash account."

I am curious as to why Rick advocates that dividends in taxable accounts NOT be automatically reinvested? How should one invest the cash from dividends?

[mikenz]

If you do not reinvest dividend distributions automatically, then you have the choice of investing that money in funds you need to top up, which can help you avoid having to sell funds to rebalance.

[Levett]

Amen to your praise, Taylor, and I said so in my Amazon review of Rick's book. Best wishes, Bob U.

[Rick Ferri]

I am curious as to why Rick advocates that dividends in taxable accounts NOT be automatically reinvested? How should one invest the cash from dividends?

In addition to the answer that mikenz gave, taxes are the other issue. Your accounting for tax-lots could get complex using dividend reinvestment. In the case you wanted to rebalance or sell shares, you will want to sell the most expensive shares first so that you can minimize capital gains (or maximize capital losses).

I do not recommend doing the average cost method where all shares are assigned the same cost. That is not your most advantageous way to track shares in a taxable account.

Rick Ferri

PS. Thanks Taylor for a great summary of THE ETF BOOK.

[baw703916]

I think the question of reinvesting ETF dividends depends to some extent on how your brokerage account works. If you have free ETF dividend reinvestment from your broker, it seems like a good deal to be able to buy the shares commission free.

Generally, I turn off dividend reinvestment for ETFs that have gone up in value and the need to be reduced for rebalancing, but reinvest dividends on the others.

Best wishes,
Brad

[SpringMan]

I found Rick's book very informative. Not just on ETFs, but also on how indexes are constructed. One question came to mind for which I do not know the answer. For individual stocks purchased, it is possible to request and take possession of certificates which can be placed in a safe deposit box etc. Does anyone know if certificates exist for ETFs?

Regards,

[Taylor Larimore]

Hi Ole Meph:

Thank you for posting those investment gems from Rick. I do have a question though. I thought buying Vanguard's S&P 500 Index and Total Stock Market Index were about as simple and effective a way of investing in U.S. equities as possible. This seems to have become more complicated with the ETF's invested in these same indexes! Some of Rick's ideas also seem to suggest that the above mentioned indexes might differ, not only in cost but in structure.

The reason I mention this is that I will be investing a lump sum amount of money in one of the two indexes, above, with Vanguard in a few months. This will be in a taxable account and will be a one time purchase. Vanguard's ETF's "seem" to be a no brainer due to their lower expense ratio. Am I missing something here? Are there other factors I should consider?

Rick can answer your question better than I can. This was his analysis in a prior post:

"Should you buy Vanguard open-end funds or Vanguard ETFs?

The answer is, it depends on costs, custody, and convenience. As a reminder, either way you are buying the same fund. VTSMX and VTI are just different share classes of the Vanguard US Total Market Fund.

Costs are a three-fold equation:

1. Expense ratio: Both the open-end and etf have management fees and administrative expenses. For example, the Vanguard Total Stock Market Index Fund investor shares VTSMX = 0.19%, VTSAX = 0.09 (Admiral shares), and VTI = 0.07% (ETF).

2. Commissions: If you buy Investor shares or Admiral shares directly through Vanguard there is no commission. However, your will pay a commission if you buy Investor shares, Admiral share or the ETF through a brokerage firm such as Fidelity, Schwab or Ameritrade. The fee for buying an open-end mutual fund is higher than buying ETF shares.

3. Trading Spread: Only applies to ETF shares that trade on an exchange. The spread is the difference between what you pay and the true NAV of the fund at the time you bought it. This can be a few pennies per share to about 25 cents depending on when you buy and the liquidity of what you are buying.

Custody is twofold (where you hold your account):

1. Direct with Vanguard: You have an account with Vanguard directly and invest in their open-end funds. There are no commissions to do this. However, you are limited to trading open-end shares once per day at the end of the day NAV.

2. Indirect with a brokerage firm: VBS, Fidelity, Schwab, Merrill et all. You will pay a commission to buy open-end funds and ETFs. Commission costs vary considerably between firms and are different for mutual funds and ETFs. Open-end funds still trade once per day at the end of the day NAV, but you can buy ETF shares anytime during the day at whatever the market price is.

If convenience is a factor:

1. You want one account with only Vanguard funds and no other investments, then open a Vanguard account and buy open-end funds.

2. You want one account with Vanguard funds and other investments, i.e. other mutual funds, stocks, bonds, ETFs, etc., then you should custody at a discount brokerage firm that gives you access to all of those investments.

So, here is how this all shakes out, IMO:

1. If you plan to buy only Vanguard funds - go directly to Vanguard. This is the least expensive option for Admiral Share class investors. For Investor Share class investors, this is still the lowest cost option if you are buying multiple funds in a diversified portfolio and if you are dollar-cost averaging.

2. If you plan to buy other investments in addition to Vanguard funds and want the convenience of one custodian - choose a low cost custodian and buy Vanguard ETFs. Don’t buy Vanguard open-end funds through a broker when ETF shares available because the commission cost is higher. That would provide the convenience you are looking for without adding to cost.

3. If you don’t care about having multiple accounts or the inconvenience trading in different places, then go with Vanguard directly for the Vanguard funds and open a low-cost custodian account for all the other stuff. See #1.

4. If you are buying only a couple of Investor Shares class one-time, then going with Vanguard directly or buying ETFs is like slitting hairs. Going through a low-cost broker and buying ETFs is probably the lowest cost option in the short-term, however direct Vanguard clients can convert Investor class shares to Admiral Shares Class when they have reached a certain level.

As we used to say in the Marine Corp, it is as clear as mud.

Rick Ferri"

Best wishes.
Taylor

[mapleosb]

Hi Rick,

Just finished your latest book. Another fantastic job. Thanks

Frank

[grabiner]

hi ole meph,

perhaps it's been critiqued here before, but i've personally found vanguard's own ETF vs. mutual fund comparison tool pretty helpful here:

https://personal.vanguard.com/us/faces/ ... sp?etfId=0

Note that Vanguard's tool doesn't allow for an Admiral conversion in the future. If you invest $10K a year in Total Stock Market Index, you'll have $100K in about eight years (assuming some market gains), and the cost of Admiral shares is the same as the cost of the ETF. If you invest $5K a year, you'll make Admiral with $50K in ten years.