ETF Investment Strategy for Moderate Risk Investors

Introduction to Investment and ETFs

Investments are the assets or items purchased with the anticipation of generating income in the future. In the economic sense, investments refer to goods and services purchased — and not consumed today — for the purpose of creating wealth in the future. Attending university or building a factory to produce goods and services are common examples of investment. Within a financial environment, investors purchase assets with the hope that those assets will appreciate over time, thereby creating wealth. Examples of financial investment include purchasing stocks or real estate property with the anticipation that their value will rise. Despite the benefits that can be derived from investing, investment is not something an individual can take lightly. Investors must implement careful planning to reap the benefits of an investment portfolio; an investor can lose his or her funds if diligent planning is not applied (Costa, 2011).

The risks involved in traditional investing portfolios are leading an increasing number of investors to divert their holdings toward Exchange Traded Funds (ETFs) as a way to guard against those risks.

The objective of this paper is to analyze different types of financial instruments available for a moderate investor. It provides an individual analysis to determine the best investment option for a moderate investor, with a focus on ETFs and portfolio fund construction.

Situation Analysis and Risk Profile

All investments with high or moderate returns carry correspondingly high or moderate risks. Investments with no risk typically deliver low returns. In the financial world, investment portfolios such as stocks, bonds, and commodities fluctuate in value, and investors who cannot tolerate such fluctuations may find traditional stock markets unsuitable. Even placing money in a savings account carries some risk. For example, an investor depositing $10,000 in a savings account might lose purchasing power if the value of the U.S. dollar falls in subsequent years. Evaluating the risk profile of a prospective investor is therefore critical before embarking on any investment program.

Our investor is a moderate investor who intends to invest in portfolios that carry moderate risk and deliver moderate returns. Costa (2011) argues that no low-risk investment carries high returns. High-return investments carry high risks, and by the same logic, moderate-risk investments involve moderate potential losses, while low-return investments involve low risks. Choosing the best investment portfolio for this client therefore requires a thorough analysis of his investment profile across four dimensions: character, lifestyle, time horizon, and objectives.

A brief interview with our prospective investor reveals that he is a moderate investor who wishes to participate in markets offering moderate returns and moderate risks. He notes that he always invests in moderate-risk instruments because of the longstanding belief that history repeats itself. Investors who seek high returns for low-risk investments tend to lose their money. For instance, many investors lost funds in the Madoff investment scheme, which advertised low risk and high returns. Furthermore, many companies collapsed in 2008 following the U.S. economic crisis, partly because financial institutions had committed to high-risk portfolios such as hedge funds, ultimately going bankrupt. Our client's disposition cannot support high-risk portfolios. Equally, he is not interested in low-risk, low-return instruments. This paper therefore recommends a moderate-return investment strategy.

Our client lives from his earnings and sets aside savings for future investment. He is looking for investments that allow him to live comfortably while maintaining a balance in his savings account.

A moderate investor generally wishes to invest for at least three years before accessing investment returns. Importantly, such an investor must be able to manage the emotions that arise from return fluctuations over that period. It is anticipated that returns may fluctuate within the first year of investment. Our client is prepared to leave his portfolio intact for three years before seeking returns, and he expressed a preference for medium-term investments. Many experienced investors recommend a medium-term horizon of between three and five years.

Our client's objective is to invest his funds in portfolios that generate a stream of income. This objective makes it critical to diversify his holdings in order to reduce volatility and risk. Accordingly, his investment plan calls for allocation across multiple asset classes, including shares, bonds, stocks, and money market instruments.

Justification of ETFs Over Mutual Funds

All investments in the contemporary environment carry some risk, including the potential loss of capital. It is critical to consider variables such as risk factors, investment objectives, and expenses before making an investment decision. Evaluating different investment products thoroughly is equally important. Investment diversification is one of the best available strategies, and this paper assesses different financial instruments with that goal in mind.

ETFs are index funds that allow the diversification of related investment portfolios. They are baskets of assets, indexes, or commodities traded similarly to stocks on a stock exchange. Like stocks and shares, ETFs are subject to price changes as they are bought and sold throughout the trading day. Unlike mutual funds, however, ETFs do not have a net asset value (NAV) calculated at the end of each day. Because ETFs allow investors to diversify across index funds, they also have the ability to sell short.

Low expense ratios are another benefit of ETFs, as the costs of managing them are lower than those of mutual funds. The most widely traded ETF is the SPDR S&P 500 ETF, traded under the symbol SPY, which tracks the S&P 500 index. ETFs are attractive to investors because of their tax efficiency, low costs, and stock-like trading features.

ETFs resemble traditional mutual funds in many ways, but they can be bought and sold throughout the day through a broker-dealer, just like individual shares. The key distinction lies in investment strategy. One or more fund managers who make active decisions about asset allocation manage traditional mutual funds; they buy and sell based on fundamental analysis and market conditions. Despite the historical popularity of mutual funds, Costa (2011) argues that the majority have underperformed their benchmarks. Approximately 4.5% of mutual funds underperform their benchmarks each year, and only 8% of active mutual funds outperform their benchmarks. In Europe, approximately 2.4% of active mutual funds underperform their benchmarks per annum, and only 17% outperform them. A major factor behind this underperformance is high management costs, which erode rates of return. For example, an active mutual fund charging 2% in asset management fees will effectively consume 33.5% of an investor's profits. An ETF charging the equivalent rate, by contrast, would take only 3.9% from an investor's profits. In practice, mutual funds charge 2% of assets rather than of profits; if an investor anticipates an 8% annual return, that means 26.5% of profits go to expenses. An ETF charging only 0.2% in expenses would consume just 2.7% per year of an investor's returns.

Availability is another significant difference. Many traditional mutual funds do not accept foreign investors; for example, U.S. mutual funds generally do not accept non-U.S. clients. By contrast, ETFs are listed on stock exchanges and can be accessed by any investor skilled in share trading. The popularity of ETFs stems from their diversity, low cost, ease of use, and transparency. Selecting ETFs will help diversify our client's investment portfolio and deliver the best return on investment (ROI).

Reviewing individual stocks remains important to ensure that they meet the stated goals. This paper focuses on ETFs because they allow an investor to build a diversified, low-cost portfolio in a manner similar to buying an individual stock. Additionally, investors can buy and sell ETFs daily, meaning prices are updated continuously as shares change hands.

Conclusion

This paper evaluates the suitability of ETFs for our prospective investor and finds that ETFs are well suited to a moderate risk-tolerance investor because of their low maintenance costs. The ETF investment portfolio also allows the investor to access a diversified pool of high-performing stocks on Wall Street, thereby capturing the strengths of each holding. Despite these benefits, the portfolio carries inherent risks — in particular, ETFs are subject to volatility in the same way as traditional stock trading. Accordingly, the ETFs selected for this portfolio have been chosen carefully to minimize exposure to investment volatility and to enable the investor to derive the full benefits of a diversified, cost-efficient investment strategy.

Costa, D. (2011). The Portable Private Banker: Investing Efficiently through Mutual Funds and ETFs. CreateSpace Independent Publishing Platform.

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