How ETFs can help with a long-term wealth strategy
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As an investor, you’re likely concerned about the stock market’s volatility, rising interest rates and inflation, so you may be looking for new investment options to diversify your portfolio. Most financial experts recommend a long-term investment strategy that generally rides out the ebb and flows of the markets.
Why a long-term strategy?
"Investing can be a tricky game full of bull markets followed by bear markets and noisy short-term changes in between," said Bryan Armour, Morningstar's director of passive strategies research for North America. "In my experience, investors make their worst decisions when responding to that noise, by making decisions based on emotions or fear of missing out. Short-term trading leads to classic investing traps like chasing returns (i.e., buying the top) or selling at the bottom. Attempting to profit by timing the market is a common mistake for retail investors and professionals alike."
Furthermore, Armour explained that long-term strategies set boundaries around trading and keep investors focused on their goals.
"Changing strategies midstream often happens at exactly the wrong time," he continued. "Long-term strategies help investors stay the course with their investments and develop good habits, like saving. This can have a tremendous impact on investors’ portfolios in the long run."
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How does diversification help achieve this goal?
Armour maintains that diversification is a key component of long-term investing.
"It helps temper volatility and preserves capital to keep portfolios compounding long-term returns," he said. "Making large bets on individual companies or a group of similar companies can lead to a higher risk of a large drawdown that could set investors back on their goals."
He said diversifying portfolio holdings across different stocks and asset classes limits exposure to any risk factor and this approach reduces drawdowns and steadies the portfolio, allowing investors to continue compounding returns over the long haul. An exchange-traded fund, or ETF, which is a basket of securities or stocks, may play a role in diversification.
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How do ETFs help with this strategy?
Armour said ETFs pool holdings and offer diversified portfolios that stretch into every corner of the market.
"Unlike mutual funds, there is no minimum investment required," he said.
To that end, he stated that there are thousands of ETFs in the U.S. that span virtually every asset class from the S&P 500 to commodities futures to hedge fund strategies to currencies and beyond.
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Benefits of ETFs
ETFs offer investors marked advantages.
One of the most significant assets of ETFs is their low cost, and Armour said their cost advantages surface in multiple ways.
First, he said there are no sales loads or fees for selling out of your position in an ETF beyond brokerage fees.
"They also often come with a lower expense ratio than mutual funds, allowing investors to keep more of their dollars compounding over the long run," he said.
Moreover, ETFs use creations and redemptions to add or remove shares of the ETF into the market, he said, often using in-kind transfers of holdings to avoid any taxable events.
"Mutual funds are often forced to buy and sell underlying securities to manage fund flows without the benefit of in-kind transfers," added Armour. "This can significantly reduce capital gains distributions for ETF holders and improve tax efficiency in taxable accounts."
Also of note, ETFs trade on exchanges allowing for intraday trading, unlike mutual funds.
"The ETF wrapper is more flexible and more transparent than traditional funds. Low costs and high transparency improve ETFs predictability, adding to their appeal," Armour continued.
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Broadly diversified passive ETFs are an excellent entry point into the market and should be the cornerstone of any long-term portfolio, said Armour.
For example, a U.S. total stock market ETF can give you access to thousands of U.S. companies in a single fund and for a fee of only a few basis points, Armour said, depending on the ETF.
"This maximizes diversification and market-value weighting ensures that the investor receives the aggregate return of the U.S. stock market over the long haul," he noted.
And, he said the diversity of asset classes offered by ETFs allows investors to easily build a portfolio that satisfies their goals.
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How life goals play a role in your investment strategy
Your life goals certainly play a role in your investment decisions. Experts say that putting a plan in place can help achieve these goals.
Janel Jackson, Vanguard’s global head of ETF capital markets and broker and index relations, said investors have the best chance to achieve their investment goals by developing a strategic asset allocation anchored on four key investment principles:
1) Setting clear, appropriate investment goals.
2) Achieving investment balance through a broadly diversified portfolio.
3) Minimizing investment costs.
4) Maintaining discipline over the long term.
EFTs can play a role in this strategy.
"No matter what phase of the investment lifetime – whether just starting out, planning for a child’s education, or getting ready for retirement – investors can construct a low-cost, broadly diversified portfolio with Vanguard ETFs to achieve their investment goals," Jackson said.
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