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Choose Passive Management and Low Fees

Passively Managed ETFs: Smart and Easy Investing

Investing can be as easy or as difficult as you want to make it. On the one hand, investing can involve a tireless degree of research into numerous types of asset classes. On the other hand, investing can be as simple as automatically channeling part of your money into a fund that essentially runs itself based on a computer program. Ironically enough, the more work you insist on doing yourself, the poorer the results you are likely to get.

When you invest in a broad index, you can average out your investment success and remove some of the downside risk. When one company does poorly and you own shares of that company, most or all of your investment can be lost. But if one company does poorly and it is only a small percentage of your investment in something far larger, your losses are minimized. Investors should find investment funds that are diversified with dozens or even hundreds of individual holdings. This will allow investors to diversify by using just one fund.

The fee structures of different kinds of mutual funds cover a wide range of values. When a highly educated human fund manager spends hours a day making sure the fund performs to the utmost extent he or she is capable of, the fee tends to be higher. The fact of the matter is that the attention of the fund manager tends to increase fees as does heavy trading. Between wanting to look “active enough” and wanting to make more fee income, the manager may trade more often than necessary. There are also tax penalties that can come about through the sale of fund assets, and you may be taxed for these sales. Clearly, investors are best served by choosing mutual funds with the lowest fees and a history of few trades. Pick funds with the lowest fees and the lowest turnovers.

An alternative approach to active managment is passive managment. Under passive managment, investments are made with simple decision rules or by a simple computer program that is based on expert research and trading. In most cases, more active management actually results in both more fees and worse performance. Choose passively managed funds as your best bet for future returns.

Investors should also opt for exchange-traded funds over traditional mutual funds. Investors are better served by exchange-traded funds than by mutual funds, because they avoid the tax consequences of a pooled investment fund like an exchange-traded fund. This allows an investor to diversify across the market without paying as much in fees or taxes. It ultimately comes down to management by a simple computer program, and often it is easier to get into and out of this type of fund.

The best of all worlds is a passively-managed, diversified ETF. These funds allow you pay less in fees and taxes, allowing your returns to be higher instead of paying a fund manager a larger amount of money. The less you pay in fees and taxes, the better you will do regardless of the daily movements of the market. Another benefit of diversifying across the market is that you will not suffer if a few holdings you or a fund manager select happen to suffer during any given period. Diversification allows you to profit from the overall upward movement of the market and remove most of the risk of serious loss resulting from the breakdowns of some companies.

Example: How Jim Selected the Best Stock ETFs

Jim managed to save $18,000 at his bank in cash and certificates of deposit (CDs), which was enough to cover $15,000 for six months of his living expenses. He is now able to invest about $3,000 in his investment portfolio. His asset allocation shows that he is a little light on stock investment, so the $3,000 should be invested in stock.

He told this to his friend Marshall. Marshall told him to invest his money through a stockbroker who charges 2.0% per year in expenses and charges penalties (sometimes called “load fees”) if you sell your investment before the end of five years. Marshall was happy with the broker, who beat the stock market returns last year. The broker invests most of his funds in just three to ten securities, because he feels he knows them well. Marshall says his broker has to trade a lot because the markets are always changing.

Fortunately, Jim decided to go against Marshall’s advice. He refused to pay high fees for active management, regardless of how good its track record was. He also refused to invest in a fund that charges load fees and that is not diversified.

Instead, Jim went to his discount online brokerage account and found many excellent diversified, low- fee stock ETFs to choose from:

The Vanguard Total World Stock Index ETF (Ticker: VT) with an expense ratio of 0.22% and an annual turnover of 10.0%. The ETF is well diversified with its ten largest holdings only accounting for 8.2% of its value.

The iShares MSCI World ETF (Ticker: URTH) with an expense ratio of 0.24% and an annual turnover of 3.0%. The ETF is well diversified with its ten largest holdings only accounting for 10.27% of its value.

The SPDR MSCI ACWI IMI ETF (Ticker: ACIM) with an expense ratio of 0.25% and low turnovers projected between the above two ETFs. This ETF is well diversified with its ten largest holdings only accounting for 6.85% of its value.

Jim realized that any of these low fee, low turnover, well-diversified, passive funds would be okay. He ended up buying $3,000 of VT shares. Marshall’s broker ended up having highly variable returns. Marshall would brag about his broker in good months and change the subject in down months. Whenever they talked about the stock market, Jim told Marshall that he was happy to earn the returns of the stock market since his ETFs hardly charged any fees at all. Jim says that he basically “fired his stock broker” and lets the market do the work!