Be your own fund manager using ETFs

The arrival of ETFs on the investing landscape, their increasing popularity and their ongoing expansion to cover more and more sectors, specific industries, commodities and market segments continues to open up more and more opportunities for passive and active investors. Having discussed many of these benefits over the past few weeks, we can now look at how we can use ETFs to effectively become our own fund manager.

The main benefits of ETFs (as discussed last week) include:-

• Ease of trading and flexibility
• Access is available from the same trading account using your existing broker
• Diversification
• Low costs
• The ability to reduce volatility within your portfolio

As active private investors we can make use of these characteristics of ETFs to run our portfolio similar to a managed fund but without the costs or hassles associated with buying a small amount of a large number of stocks or other instruments in an attempt to replicate an index or industry sector.

Instead, we can use ETFs in a number of ways or combinations to achieve our investing goals and achieve what we all want, better growth and performance of our capital than we otherwise would have achieved by not being our own fund manager.

Over the next few weeks we will cover some of the many ways ETFs can be used when managing your own money to become your own fund manager. The first of these is a single ETF strategy.

Single ETF strategy

Prior to the emergence of ETFs, the only real way to ‘follow’ an Index, such as the S&P500 or ASX200, was to invest in a mutual fund or managed fund that tracked the index through a basket of stocks that replicated that index. This meant paying fees and charges to the fund manager for managing your money which, for index funds, was less than active fund manager fees.

The investment process for both index and active funds required completing a prospectus and sending a cheque to buy, completing a redemption form to sell, or completing a switching form to switch between funds.

The other alternatives were to invest in Listed Investment Companies (LICs) or to attempt to replicate the index yourself by buying the shares that constitute that index proportional to the cash you have available. This obviously has drawbacks for many in terms of the time involved, brokerage costs, volatility and stock selection!

Now, if your desire is to achieve a return that is consistent with the return of a major Index, such as the S&P500 or the NASDAQ, then you can simply buy the ETF that tracks that index – SPY in the case of the S&P500, QQQ for the NASDAQ and STW in the case of the ASX200. ETFs are available over a large number of stock market indices, so the index return you hope to match is limited only by the availability of an ETF over that Index.

This strategy is not dissimilar to the old ‘buy and hold’ strategy, as it uses NO timing techniques for entry and exit. It does however allow for collection of dividends as and when they are paid and removes volatility that would occur from individual stock movements and different position sizes in individual stocks.

According to research conducted by S&P Dow Jones Indices SPIVA© Scorecard, this strategy over the long term can outperform around 70% (it varies to more and less every 6 months when their research is released) of active fund managers in the USA and Australia.

This single ETF strategy can also be applied to a sector index if you believe in a sector over the long term, such as the NASDAQ Pharmaceuticals index or a Healthcare sector index.

As an active investor with a strategy or trading plan that involves the use of technical analysis, the potential exists to outperform the chosen index through the timing of entries and exits based on a proven trading methodology. We will look into this in greater detail next week.