The educational starting point for all investors new to ETFs, be they novice or experienced professional, ought to be Investment Cart & Horse 101.
ETFs enable investors to clearly and objectively distinguish, both in investment thinking and in investment practice, between the proverbial “cart” and “horse“, i.e., the investment instrument and investment strategy.
The gross mismatch between an active fund manager’s stated investment objective(s), and the broad (prospectus-imparted) license to roam widely and at will across much of the investment landscape, renders separation of investment instrument from investment strategy absolutely and utterly impossible to discern within the actively-managed mutual fund.
For investors and advisors, unfortunately, any attempt to use actively-managed mutual funds to construct a disciplined and coherent strategy – one which demands control and predictability regarding the composition of portfolio holdings – is inescapably and entirely rendered an exercise in futility. “Asset allocation” strategies, at best, devolve to an extremely crude approximation game as individual fund managers exercise broad discretion in modifying, at times quite dramatically, security and asset class composition within their funds. Gone, usurped by active mutual fund managers, is investor or advisor control over the composition and modification of their strategy.
In contrast, index-based ETF instruments provide a systematic, rules-based recipe for gaining exposure to a broad market or segment of a market. And while mutual fund reported holdings data ranges from three to five months stale, daily reporting of ETF holdings enables the investor or advisor to see precisely how index rules are reflected in a related ETF’s holdings. For the investor or advisor familiar with the index and the ETF, there are no surprises regarding the composition of an ETF. The manner of asset class coverage and security selection are “programmed” into the index and corresponding ETF.
Utilization of index-based ETFs enables the investor and advisor to shed active-manager decision-making risks – a step that is supported by a mountain of academic research and decades of market experience. With index-based ETFs, investor and advisor attention can be focused where it should be: entirely on strategy, understanding that the instruments will deliver intended exposures predictably and reliably. Actively-managed mutual funds rob investors of this capability by undermining the strategy, through manager drift, and weakening investor confidence and resolve to stick with a game plan. Active fund mangers, after all, have no definitive requirement or proclivity to do so themselves.
In using ETFs, investors and advisors are better equipped to construct and deploy strategies as well as to consider the performance of instruments and strategies independently, largely as a result of their ability to “separate the cart from the horse.” These risk management and control perspectives can never be shared or enjoyed by investors and advisors using actively-managed mutual funds.
