by James B. Cloonan

In the August 2006 AAII Journal, we began a Model ETF Portfolio.

We indicated that it was an experimental portfolio meant for the examination of exchange-traded funds (ETF). which were quite new at the time. While ETFs are still relatively newfew have a 10-year historywe feel we can make some judgments and integrate ETFs into an overall fund portfolio.

While it is handy to keep traditional mutual funds, ETFs and closed-end funds separate when listing them or reporting on them, an effective fund portfolio should combine them to take advantage of the strengths of each. That is exactly what we have done by making major changes to our Model Fund Portfolio.

Closed-end funds are mutual funds with a fixed number of shares that can only be purchased or sold through exchanges. The share price may deviate from the net asset value (NAV). With a traditional mutual fund, investors buy and sell an unlimited or open number of shares once per day, directly through the fund at the NAV. Exchange-traded funds trade on exchanges like closed-end funds, but the fund also buys and sells shares directly with authorized participants to help keep the ETF market price close to the NAV.

ETFs and Funds

The following is my opinion of the relative strengths and weaknesses of ETFs and traditional mutual funds. Closed-end funds seem more applicable to bond investing. We have not found any closed-end funds that seem appropriate for a stock portfolio, except perhaps to speculate in a specific area that does not yet have an ETF.

Let me emphasize that we are concerned here only with the equity portion of an investment portfolio and a long-term investment horizon. There is no attempt to switch funds based on short-term prognostications about which sector or subcategory will do best in the short run.

Exchange-Traded Funds

The major advantages I find for exchange-traded funds are their generally lower expenses, the ability to buy and sell them at anytime the market is open, and the ability to tax-manage them according to individual requirements. In coming articles, I will expand on each of these advantages. If an investor believes in the efficient market of modern portfolio theory, then ETFs can be a complete answer to effective investing.

If an investor believes, as we do, that there are significant inefficiencies that can be exploited, then index funds cannot be the only approach. ETFs are limited to portfolios that are, or can be, indexed. There has been discussion of more actively managed ETFs, but if there is no comparable index, or if a created index cannot easily be purchased in the marketplace, then there is no ability for arbitrage and the ETFs share price in the marketplace can deviate from the market value of the securities held. As in the case of closed-end funds, the deviation can be quite wide, particularly in a less-active market segment.

Some of the more well-known anomalies, such as market capitalization and measures of value, can be at least partially accomplished in an ETF portfolio, and our new Model Fund Portfolio uses them for that purpose as well as for diversification.