What Is An ETF?
Exchange-traded funds (ETFs) are the least expensive and most tax-efficient type of index fund.
ETFs allow you to invest in practically any market at very low cost. They trade on the stock exchange and can be purchased through any discount broker—just like a stock—at a cost averaging between $4 and $10 per trade (and commission-free at some brokers). ETF management fees for Rebalance IRA average less than 0.2% per year.
More than 1,200 ETFs have been created. As a group, these funds now hold $1 trillion in assets. Understandably, the wide variety of ETFs has led to investor confusion about which funds are most suitable for building an asset allocation.
Not all ETFs are created equal, it’s true. Fund selection is based upon several criteria:
1. exposure to core asset classes.
Since our methodology is based upon modern portfolio theory, we seek exposure to broad asset classes that have three common characteristics:
they provide a valuable counterbalancing effect within an investment portfolio. For example, real estate offsets inflation, but bonds protect against a financial crisis,
they rely fundamentally on market-generated returns, not on active management of portfolios. In most asset classes, active managers cannot outperform the market. Because meeting our investment objectives is critical, a core asset class cannot be based on “lucky picks” and
they are selected from broad, deep, liquid markets, for safety and flexibility.
As a core building block of a portfolio, we focus on well-established marketplaces, not sector funds (such as technology) or indexes based upon a fashionable, “flavor-of-the-month” thinking, such as a quant method of reweighting stocks.
2. asset size
Rebalance only uses the largest ETFs, averaging $6 billion in net assets with volumes of more than 1 million shares per day. This affords sufficient liquidity and provides narrow bid/ask spreads, reducing both cost and risk.
3. fees
The typical weighted portfolio of ETFs we use features an average fee of less than 0.2%. Low fees are the key to achieving higher returns.
4. sponsors
Rebalance uses ETFs sold by proven, well-known providers, such as Vanguard, iShares, and State Street Bank and Trust. These three firms account for nearly 90% of all ETF assets and are the most highly regarded in the industry. Vanguard is a not-for-profit institution and has the lowest fees, so it tends to keep the other ETF providers “honest.” In addition, the skill sets and technology for managing and constructing ETFs are highest among these three firms.
5. index construction
ETFs are evaluated based upon index construction. We seek funds that precisely replicate a given index’s performance over long periods. There are as well various ways to index a market. For example, small cap U.S. stocks are generally indexed using the Russell 2000 Index. But the S&P SmallCap 600 Index is a superior alternative, due to its construction and how it avoids the drag from what is known as the annual “Russell 2000 trade.”
