Anders Geertsen Ph.D
Contributing Writer
instructor@mywealth.com
In my last article, I argued that the stock market was undervalued with the level of 750 on the S&P 500. Since then, the market has surged almost 10% and is currently trading at 820. At this level, I think the market is still relatively a good value.
As I wrote in the last article, the 10 year trailing operating earnings for the S&P 500 is around 60. So at 820 you’re paying less than 14 times earnings. That’s less than the long run average of 16, and the market has historically returned in the neighborhood of 7-10% annualized if you invest at these levels.
However, just because the market is inexpensive on a 10-year earnings average doesn’t mean it cannot go down in the short run. It could go lower because of more bad news. But if you can hold over the next 5-10 years, the current levels probably offer an attractive entry point. I think this holds true until the market starts to trade at its intrinsic value, which many observers currently peg around 950 – 1050 on the S&P 500.
In this article, I’ll follow up on the third rule I mentioned in my last article: Diversify and use lows cost ETFs. Of course, before you invest at all, you need to make sure your own financial house is in order (see Bob O’Brien’s excellent article on financial planning).
Assuming that your finances are in order, you should stick to a simple investing philosophy: You invest when the time is right (as it is now) and stay out when the markets are overpriced. And you stay away from expensive mutual funds that cost you 1% or 2% in fees without providing any value in return.
For most investors, the best investing vehicle is an ETF, or short hand for Exchange Traded Fund. These funds trade like stocks, but are really a basket of stocks that aim to track an index. ETFs offer a low cost way to get market exposure and diversification. Many ultra high net worth individuals and foundations use these funds, and for the average investor (with a million dollars or less in liquid assets) they are probably the most efficient and lowest cost way to get access to the market.
Even though ETFs are generally a lot cheaper than mutual funds, they do come in different variations, and some have fees that approach those of traditional mutual funds (1% - 2%). Since I care about fees, I tend to prefer the lowest cost ETFs. They are typically the ETFs that track the major indices, such as the S&P 500 or the EAFE index of developed countries, or the major emerging markets. The “plain vanilla” ETFs are the cheapest and simplest to use, and by cheap I mean really cheap. They often cost less than 0.25% of your assets.
One of the most basic ETFs is the fund that tracks the S&P 500 index. This ETF has symbol SPY. You can check the current price on any financial website, and you can buy and sell it on the exchange just as with a regular stock. The advantage of owning the SPY is that you get exposure to the whole S&P 500 index, without buying every single stock in that index, and without buying a mutual fund that aims to match (or beat) the index.
For this diversification, you pay a very modest fee (or expense ratio, as it’s called) – currently 0.08%. On a $100,000 investment, that amounts to $80 a year. It doesn’t get cheaper than that! To learn more about this and other ETFs, check out our Investing Course.
Originally, ETFs only tracked the main indices but today you can get them in many flavors and shapes. There are ETFs that track emerging markets, the clean tech industry, China or Brazil, as well as ETFs that place inverse bets on indices – that is, they go up if the index goes down. There are even levered ETFs, which means you get twice or three times the exposure of a regular index.
I think you should keep it simple with ETFs. Stay with the funds that track large industries or broad sectors. Stay away from the very specialized funds unless you have specific knowledge that other market participants don’t have. As for levered ETFs, I think you should stay far away from those. While the plain vanilla funds can be excellent investment tools that provide you cheap diversification and access to many markets, the levered ETFs are the Las Vegas version of investing vehicles as I will explain below.
Why levered ETFs will eat your money!
Say you buy a levered ETF that aims to track twice the daily movements in the S&P500 and that you hold it for a few days where the S&P500 is volatile (that is, it goes up and down a lot). For illustration let’s say that the market goes down 20% the first day and then up 25% the next day, to break even (if the index is initially at 100, it would decline to 80 and then add 20, to go back to 100).
Your levered ETF, by design, would go down twice as much as the market on the first day, and up twice as much on the second day. So you’d be down 40% on the first day, and up 50% on the second day. But that would leave you 10% down at the end of the day: If you were initially at 100, you’d decline to 60, and then add 30 to end at 90.
So while the index breaks even, your levered ETF actually declines. It’s even worse for the levered inverse ETFs. In the example above, let’s say you bought the levered inverse ETF that tracks twice the inverse daily changes of the S&P 500. If you start out at 100, you’d be up 40% after the first day and down 50% on the second day. So you’d be at 140 after the first day, and cut in half to 70 after the second day. In sum, you’d be down 30% from where you started.
The levered ETFs work this way because of compounding effects. And as you can see, in volatile markets they have a tendency to decline. Over time, they tend to go towards zero. Many investors have realized this in practice. They buy a levered ETF to “up the ante” only to get knocked down by volatility.
These products tend to work only for short term trades where you get the direction right! Unless you have superior market timing skills you should be very careful in using these products. If you want exposure to the markets, in most cases you’d be better off buying a regular ETF when the price is right and hold it for the long term.
Be sure to check out our Investing Course where we can help you determine an investment strategy that is best for you! A $25 investment to avoid thousand dollar mistakes is always a great investment!
Contributing Writer,
Anders Geertsen Ph.D.
