How To Use ETFs To Measure Your Mutual Funds

Posted on September 27, 2010 at 10:28 AM PST by

“Once I had fame, oh I was full of pride, had lots of friends, always here right by my side, well my fame oh it died, now my friends all try to hide, everybody loves a winner … but when you lose, you lose alone.” – William Bell, “Everybody Loves A Winner”

In all highly competitive pursuits in which every aspect of performance is carefully measured and the statistics are clear and understandable, the winners and losers are easily identified. In sports, we know exactly why the top players are paid their salaries-because they put up the numbers, be it RBIs or assists. In music, top-grossing bands play the amphitheaters while the others play the local nightclubs. And, like the old song says, when your numbers fade, so does fame and fortune-with one big exception.

The mutual fund industry has figured out how to never be a loser. Faced with statistics which indisputably show that over time a mutual fund has just a 1 in 3 chance of winning (beating its benchmark), the industry has developed ways of obfuscating true performance so that when a fund loses, no one has to know about it. There are several legally sanctioned ways that a mutual fund can say it won when it really lost. For example, if a small mutual fund with a great track record merges with a large one with a terrible record, the large one can assume and advertise the small one’s record. That’s one of many reasons smart investors don’t rely on the advertised performance numbers of a mutual fund.

Fortunately, as an investor, you have two ways to invest in any category: you can buy all of the securities in that category’s index with an exchange-traded fund or pay, on average, eight times more for a well-educated investment professional to select stocks within that index with a mutual fund.

To use an ETF to measure performance, buy one as a kind of thermometer. Let’s say that when the market closes tonight you have $45,000 invested in either a mutual fund or your own portfolio of emerging market stocks. Let’s say that the Vanguard Emerging Markets ETF (VWO), which indexes the largest 825 stocks in the 28 emerging market countries closed at $45 per share tonight. Buy an exact number of shares of VWO that represents a fraction of your actual portfolio in the same account. In this example, if you bought 10 shares of VWO you would have $450 to watch against your $45,000 portfolio. Now you’ll have a built-in way to measure your portfolio’s performance. If at the end of the year, your portfolio is worth $50,000 but your VWO position is worth $550, then you are losing because the computer-run ETF beat the mutual fund pro.

There are ETFs to match most any index, and they come with lower costs than mutual funds. If you want to own all 500 stocks in the S&P 500 Index, buy the SPDR S&P 500 ETF (SPY) to get access to the entire S&P 500 index for an annual cost of .09 percent, or pay 1 percent (10 times more) for a large-cap U.S. stock fund. If you want to own stocks in the emerging markets like Brazil, India, Russia, and China, buy VWO for just 0.27 percent, or pay 2 percent (about 8 times more) for a mutual fund that attempts to pick the winners.

ETFs also make it easy to measure the true performance of mutual funds, hedge funds, and yes, even your own stock picking abilities. For every investment category-for example government bonds, corporate bonds, U.S. stocks (small-cap, large-cap, mid-cap, growth, value), and international-there’s an index that contains every security in that category.

Investing is serious, and knowing with certainty whether you are a winner or a loser is a critical part of the game. ETFs are a great tool for learning the truth. Letting a mutual fund tell you how well it performed is like letting a 3rd grader grade his own math test-it is not a wise idea. And if you pick your own stocks, find out if you are engaging in expensive entertainment or if you are defying the odds.

Here are a few newsworthy articles from this week:

MarketRiders Now Weekly Contributor To US News– Our friend Kirk Shinkle at US News liked our newsletter so much that he honored us with a coveted position as a regular contributor on their site. We will now post a version of this newsletter to “The Smarter Investor” each week. You can read this newsletter or bookmark us on US News here.

Daily Finance: Fear Is Hazardous to Your Financial Health– We’ve written about this concept in the past but this blog is another great reminder that as humans, our mental “wiring” predisposes us to be bad investors. That wiring signals us to buy when we’re happy and stocks are going up and to sell when we’re panicked and stocks are going down. A MarketRiders rebalancing alert signals the exact opposite.

Forbes: How To Construct The Perfect Portfolio– As we’ve continually said, our MarketRiders strategy was developed for the wealthy and the elite by Nobel Laureates. It has withstood the furnaces of institutional investing for decades. Forbes reconfirmed that there is strategic asset allocation which is how our service works, or strategies based upon guessing the winds of the market that fail over time.