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5 Reasons Your Portfolio Needs More ETFs And Index Funds

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Even though exchange-traded funds (ETFs) and index funds have gained mainstream popularity over the past 10-years a lot of investors have yet to fully embrace them. There are numerous reasons for this, but the bottom line for investors is that there’s likely no easier or cost effective way to improve a portfolio than to replace most of the mutual funds, hedge funds, and structured products with inexpensive exchange-traded funds and indexes.

Here are five reasons why index-based ETFs are worthy of a dominant role in most portfolios:

1 – Lower Expenses. Most ETFs cost less than 0.40% annually, and many of the large-cap index-based funds charge less than 0.10%.

By comparison, most equity mutual funds cost (in total) about 2 percent annually. The 2 percent total expense includes not only the average equity funds disclosed expense ratio (1.20) but also the hidden transaction costs that on average add about 1 percent annually to the total expense.

And hedge funds typically charge 2 percent annually plus 20 percent of the gains. To consider the impact this has on a portfolio, here’s a graph from FundReference illustrating the difference in performance of the S&P 500 with an ETF expense of 0.17%, and a 2 and 20 hedge fund expense.

As this chart clearly shows, there is a great wealth opportunity in the hedge fund industry. It’s just not the one that most hedge fund investors think it is.

Bottom line: Expenses matter - especially over the long term.

2 – Performance. On average, mutual funds, hedge funds, and structured investment products have not outperformed their corresponding benchmark index, and that’s especially true over the past 3, 5, and 10-year periods.

According to S&P Dow Jones Indices, more than 86 percent of large-cap fund managers underperformed their benchmark index in 2014. And over the past five-years, 88 percent of active fund managers underperformed.

Ultimately, optimal performance is what we’re all striving for. While past performance is not a guarantee of future returns, if history is any indication, mutual funds, hedge funds, and structured products show no sign of being high probability vehicles of optimal performance. Yet, most individual investors today still have portfolios largely comprised of these holdings.

3 – Tax Efficiency. This is likely one of the most underappreciated advantages to investing in ETFs. The fact is most index-based ETFs experience very little turnover, and it’s extremely rare to have a taxable event while holding them.

For wealthy investors in higher tax brackets, the tax efficiency can make a substantial difference to their after-tax performance. ETFs are also exceptionally easy to manage for tax loss harvesting because they are easily traded with a reliably fixed cost basis.

ETFs have been around for about 20 years, and over that time-period have proven to be the most tax efficient fund structure on the market.

4 – Transparent Diversification. Another primary benefit to ETFs and index funds over actively managed mutual funds and other actively managed investment products is that there’s no need to wonder what the different product managers are changing, and how that impacts the risk and balance of your overall portfolio.

With index funds and ETFs, you can achieve significant diversification with a handful of funds, and you always know what your asset allocation is.

5 – Investment Liquidity. ETFs are usually extremely liquid and can be easily traded during market hours. Unlike many mutual funds, there should never be up-front sales commissions, or back-end surrender expenses. And unlike hedge funds and some other structured products, there are no lock-up periods, and investors can easily determine their market value whenever the markets are open.

In closing, there are numerous aspects to investing that are not at all obvious or easy. But adding index-based ETFs to a portfolio while reducing the number of mutual funds and investment products is likely one of the easiest and most beneficial moves an investor can make.

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