A key to building a successful portfolio that includes exchange-traded funds (ETFs), right up there with low costs and tax efficiency, is diversification. You cannot diversify optimally unless you know exactly what’s in your portfolio.
In a rather infamous example, when tech stocks (some more than others) started to go belly up in 2000, holders of Janus mutual funds got clobbered. That’s because they learned after the fact that their three or four Janus mutual funds, which gave the illusion of diversification, were actually holding many of the same stocks.
Style drift: An epidemic
With a mutual fund, you often have little idea of what stocks the fund manager is holding. In fact, you may not even know what kinds of stocks he is holding. Or even if he is holding stocks! This is called style drift, which occurs when a mutual fund manager advertises his fund as aggressive, but over time it becomes conservative, and vice versa.
One classic case of style drift cost investors in the all-popular Fidelity Magellan Fund a bundle. The year was 1996, and then fund manager Jeffrey Vinik reduced the stock holdings in his “stock” mutual fund to 70 percent. He had 30 percent of the fund’s assets in either bonds or short-term securities.
He was betting that the market was going to sour, and he was planning to fully invest in stocks after that happened. He was dead wrong. Instead, the market continued to soar, bonds took a dive, Fidelity Magellan seriously underperformed, and Vinik was out.
One study by the Association of Investment Management concluded that a full 40 percent of actively managed mutual funds are not what they say they are. Some funds bounce around in style so much that an investor would have almost no idea where her money was.
The Parnassus Fund, for example, was once placed by Morningstar in the small cap blend category. Then it moved to small cap value. Later it moved to mid cap blend. Later still, the fund was reclassified as mid cap growth.
ETFs are the cure
When you buy an indexed ETF, you get complete transparency. You know exactly what you are buying. No matter what the ETF, you can see in the prospectus or on the ETF provider’s website (or on any number of independent financial websites) a complete picture of the ETF’s holdings.
See, for example, either CEF Connect or Yahoo! Finance. Go to either website and type the letters IYE (the ticker symbol for the iShares Dow Jones U.S. Energy Sector ETF) in the box in the upper right of the screen, and you can see in an instant what your holdings are (if you hold stock in the iShares Dow Jones U.S. Energy Sector ETF).
You simply can’t get that information on most actively managed mutual funds. Or if you can, the information is both stale and subject to change without notice.
Transparency also discourages dishonesty
The scandals that have rocked the mutual fund world over the years have left the world of ETFs untouched. There’s not a whole lot of manipulation that a fund manager can do when his picks are tied to an index.
And because ETFs trade throughout the day, with the price flashing across thousands of computer screens worldwide, there is no room to take advantage of the “stale” pricing that occurs after the markets close and mutual fund orders are settled. All in all, ETF investors are much less likely ever to get bamboozled than are investors in active mutual funds.