ETF Argument, This Nerd Weighs In

The fallout and debate from both the Kauffman Report and Bogan Paper continues to flow which is a positive for anyone trying to figure out their best way to construct a portfolio. The latest contribution to the discussion comes from Kendall Anderson in a post called Seven Questions For ETF Investors. Quite candidly it is not crystal clear which side Anderson is taking as after excerpting Matt Hougan from a couple of sources all the article does is ask seven questions. It seems as though he favors individual stocks over ETFs as the tone of the questions is along the lines of how can looking at an entire market or economy be simpler than looking at one individual stock but I am not 100% certain. My post will presume that Anderson is not a fan of ETFs.

Anderson takes Matt to task for saying "the truth of the matter is that most individual investors have no business owing individual stocks as the core of their portfolios.It's impossible to get truly diversified, and even harder to stay up on the research for more than a handful of securities." Later in the post Anderson circles back and asks rhetorically how many securities does it take to get truly diversified and how many securities is a handful?

Both points of view miss the mark. The notion that most individual investors have no business with individual stocks is a gross generalization. As I have said many times I think portfolio construction will boil down to time available to spend on the task. Someone who is interested enough in investing to spend a couple of hours on Saturday morning and 20 minutes every night during the week could probably handle a couple of stocks integrated into a portfolio of funds (exchange traded or otherwise).

However one builds a portfolio, it will be a series of different exposures that come together to form some combo that is expected to deliver something close to the desired result. For the portfolios I construct, I want a globally diversified portfolio that avoids big bets. Whatever number of exposures you think is ideal, for me the number is between 30 and 40 for accounts above a certain size, you must select something for each of those exposures. In this context I will say you owe it to yourself to seek out the best possible way to capture that exposure, in your opinion, and be agnostic about the wrapper. To repeat from past posts, it makes no sense that any one wrapper can possibly be the best wrapper for all segments of the market.

From the top down an investor wanting to buy Colombia might do some research and find the Global X Colombia ETF (GXG) and Bancolombia (CIB). The two correlate very closely and while I am not sure which one would be "better" it is easy to imagine that someone doing some research would draw some conclusion about which one is better. If you are a fund investor and think the stock would be the better choice are you really going to buy the fund instead?

From the bottom up an investor wanting smartphone exposure might stumble across Apple (AAPL), Research in Motion (RIMM) or an ETF like QQQQ which allocates 19% to AAPL. The best way in is in the eye of the beholder but why would someone put money into what they think is the second best way in? Your own time constraints, assuming ordinary acumen, will dictate how narrow your portfolio should be.

Anderson makes a point about simplicity that I think also misses the mark. He asks "How can it be easier to analyze the S&P 500 Index than it can be to analyze IBM (IBM) or Cisco (CSCO), when IBM and Cisco are just two of the 500 companies included in the index?" and "do you really think it is easier to analyze the Chinese or U.S. economies than it is to analyze an individual company such as IBM or Cisco?" There can be no single, always correct answer to this line of questioning.

To answer the first question if the S&P 500 is below its 200 DMA demand for equities can be thought of as being unhealthy. This analysis can be done as fast as your ISP can load the page. This is of course a top down concept but has served me well thus far. Another example; Ireland's debt to GDP is how big and where might it go? If you have no idea then it would probably take anywhere from two to ten minutes with a search engine.

Figuring out what to avoid can be just as important as figuring out what to buy; this is ground we've covered many times over the years. Sometimes sizing up a country can be pretty simple. Sizing up a stock might be more complicated that that but it might not, again there is no single answer.

Maybe other people need to dig in to defend a position but you do not. Be product agnostic and use whatever tool that best captures each exposure you want in your portfolio.