ETFs and the Model Fund Portfolio

Comments posted to “Frontier Markets Exposure Added to the Model Fund Portfolio,” by James B. Cloonan, in the August 2013 AAII Journal:

Is there a pure ETF portfolio in which we could invest and follow at AAII?

—Diane Sracic from Florida

I have been researching exchange-traded funds. Vanguard has really low expense ratios and Morningstar seems to like a lot of them. What is the reason for not having any Vanguard ETFs, except the Vanguard REIT Index fund?

—Barbara Kristoff from California

James Cloonan responds:

We previously had separate model fund and ETF portfolios. But there are different areas where each is most effective, so we combined them into one model portfolio.

Exchange-traded funds are still primarily for index investing, and some approaches to the market cannot be indexed.

Vanguard is dominated by an index approach, and cap-weighted indexes at that. If one wants to go with an index, Vanguard is great, although equal-weighted indexes will do better.

Understanding ETFs

Comment posted to “The Individual Investor’s Guide to Exchange-Traded Funds 2013” in the August 2013 AAII Journal:

Written well for the average investor to understand the world of ETFs.

—Arnold Chong from Iowa

Navigating the Bid/Ask Spread on ETFs

Comment posted to “ETFs and ETNs: Knowing What You Own,” by Neil Leeson, in the August 2013 AAII Journal:

Since I am a novice investor, I invest in index mutual funds that have low expense ratios. ETFs appear to have the additional expense of dealing with the spread between the bid and asked prices. How much does the spread add to the expense ratio? Is there any way to get a handle on which ETFs or family of ETFs have the narrowest spreads?

Are inverse ETFs just for short-term use? I am tempted to invest in an inverse long-term bond fund for an extended period of time.

—Arnie Zimmer from Virginia

Editor Charles Rotblut responds:

The bid-ask spreads are transaction costs, which you only pay when you buy or sell an ETF. Conversely, the management and other fees, which are measured by the expense ratio, are paid every year you own the fund. I would be far more concerned with picking the best fund for the asset class that you are trying to target than trying to seek the narrowest bid-ask spread.

As far as inverse ETFs are concerned, read the prospectus. Many only give you the opposite return for a single day. After one day, the ETF’s return starts to differ increasingly from that of the underlying security.

Variable Spending in Retirement

Comment posted to “Safe Withdrawal Rates and Certainty-Equivalent Spending,” by Druce Vertes, in the July 2013 AAII Journal:

I’m not clear as to the meanings for the columns in Table 1, showing the initial spending shortfall severity frontier. How would the 4% line in the table play out for a $100,000 portfolio?

—RDV from Florida

Druce Vertes responds:

I wouldn’t get too hung up on the math. The point is, historically a 4% fixed rule worked. But since, as tested by William Bengen, that rule never goes up as the portfolio goes up, it doesn’t lead to high lifetime spending. If you incorporate a variable term, you get higher lifetime spending, but you have to accept some risk of a shortfall.

It’s interesting to chart that relationship and see how much additional lifetime spending you get by accepting different degrees of shortfall risk.

“Certainty-equivalent spending” is a concept that 1) lets you compare different strategies based on your level of risk aversion and 2) shows us that if you’re highly risk-averse, you’ll stick with something like the fixed 4% rule. If you’re risk-neutral, you’ll just try to maximize lifetime spending with a strategy that varies based on the size of the portfolio.