Archives for March 2017

In this ETFdb interview with Rich Powers, Head of ETF Product Management at Vanguard, there was a useful bit about the practical mechanics of buying an ETF in your brokerage account. Found via Abnormal Returns.

ETFdb: What would you say are three best practices that investors should keep in mind?

R.P.: The first is to not trade at the open or the close because the markets aren’t very deep during these times. Secondly, avoid market orders at all costs. Finally, investors need to keep their risk/return profile and expectations in mind. A retail investor will have a different set of parameters and risks that they are willing and able to bear, compared to an institutional investor, when selecting a product.

ETFs are an increasingly popular way to build a portfolio and this is good, practical advice from a respected source. I’ll expand with my own commentary below:

Do not trade near the open or close each trading day. The markets are not as liquid during these times, which means that you may get poor pricing. I’ve read elsewhere that you shouldn’t trade during the first hour or the last hour of the trading day. I’ve found this to be a good rule of thumb.

Never use a market order. A market order is like a box of chocolates… you never know what you’re going to get. A limit order simply sets a ceiling on the price you’ll pay to buy (floor on selling). A market order has no theoretical boundary, as you’re saying “just buy/sell it for whatever is the lowest/highest price available at this moment in time”. For example, if you are selling your shares and the bid on an ETF is $100.00 and the ask is $100.20, your market order could still be filled at $90 or even $50 if there is some sort of “flash crash” event. Why take that risk?

You can use a limit order that is as “strict” or “lenient” as you like. I’ve read recommendations to set a limit order for the middle of the bid/ask spread, i.e. $100.10 in the previous example. It isn’t a bad idea, but I don’t use this rule. Let’s say I’m trying to invest roughly $5,000 and thus roughly 50 shares. The difference between $100.00 and $100.10 a share times 50 shares is $5. Am I going to risk not making this buy order over $5? The market could just as easily move upwards to $100.50 as it could go down to $99.50, so any future price movement could dwarf that $5.

Since I am a long-term investor, I just want the trade to go through within a reasonable price range, so I usually choose a limit order close to the bid. Note that this padding should not be an invitation to get ripped off. I routinely get order fills above my limit price. There is an SEC rule called “best execution“. This is from a now-gone Schwab article that I’ve quoted in the past:

Markets are not allowed to fill orders at a price worse than the market price, even if your limit order allows for it. Building in a little extra room to ensure your order is filled will not cause you to overpay—you should still be filled at the prevailing market price when your order comes to the front of the line.

Don’t try to time the market quotes intraday. I’m replacing Mr. Powers’ third best practice with this one, which is supported by a later quote in the interview:

[…] retail or individual investors probably do not benefit from being able to trade an ETF throughout the day.

Since you have to buy an ETF during the day, you may be tempted to delay your purchase if the market appears to be moving upwards or downwards. “If I wait, the price might go back down a bit!”… or “If I wait, the price might go up some more!”. If you are a long-term investor and not a trader, then just type in your limit order and get back to your life. Most of the time my orders fill immediately. Sometimes the market moves and it doesn’t fill right away. I usually just walk away, only to have it fill minutes later. A few times, I forget and the order expires at the end of the day. In that case, I just spend 2 minutes typing in the order again the next day. Don’t worry about daily movements, you can’t predict them anyway.

Institutional Investor has an interesting profile of Dimensional Fund Advisors (DFA). Since DFA doesn’t do much marketing, there are very few articles about them in the mainstream financial media. A rare example is this 2007 article (backup copy) by Michael Lewis for a now-defunct magazine.

DFA funds are similar to Vanguard index funds in that they provide low-cost, diversified, tax-efficient funds that try to capture the market’s overall return. DFA differs from Vanguard in that it tries to beat an index benchmark with various tweaks that target systemic market “risk factors” including size, value, and profitability. (They still believe that prices are efficient and thus don’t pick specific stocks.) They also charge a bit more than pure index funds from Vanguard, Fidelity, Schwab, and iShares.

DFA doesn’t accept money directly from individual investors. You must buy their funds through approved financial advisors or via institutional accounts like 401(k), pension, and 529 plans. Their rationale is that retail investors move their money around too much and at the wrong time. Here’s an impressive statistic:

In 2008, while investors pulled an overall $500 billion from equity funds, the firm had positive flows. It wasn’t because of performance: Dimensional’s funds lost more than the market. According to the group gathered for the September dinner in Austin, clients chose to stay because they understood the firm’s philosophy and the small judgment calls it was making on market portfolios.

DFA is privately-owned and highly academic. DFA executives are “engineers, Nobel Prize winners, physicists, and fluid-mechanics experts”. As such, they are all about the science as opposed to the marketing. The article asks what will happen when the founding members eventually die or leave the firm. Will it have an IPO and be publicly-traded? Will this change the culture to be more focused on short-term profits? Will they someday allow Average Jane investors with $500 to invest? Will the new executives be able to continue the superior performance from understanding market factors?

Succession an interesting question that comes up whenever there is a “special sauce” to your investment’s outperformance. I think Vanguard has done a pretty good job of moving on without Bogle, and I can’t name the current CEO. If you own plain, vanilla index funds there are fewer risks tied to specific people. To simply achieve market return at rock-bottom costs, the current structure should still work 50 or 100 years from now.

DFA doesn’t offer a momentum strategy. The hot trend right now is “smart beta”, and momentum is a big part of that:

It’s instructive to consider other things Dimensional doesn’t have. For example, it doesn’t offer a momentum stock strategy even though the pattern of outperformance is seen clearly in the data. The firm believes a portfolio of momentum stocks generates too much turnover and creates a fund whose characteristics look very different from a market portfolio. Instead, Dimensional uses information on momentum to inform its trading strategies, such as delaying purchases and sales at certain times.

Owning a little bit of DFA funds. I remain intrigued by DFA and their unique culture and methods. Since DFA doesn’t trust us DIY investors (probably rightfully so in aggregate) and many financial advisors charge roughly 1% annually on top of the higher costs of DFA funds themselves, I choose not to invest in DFA funds with my primary portfolio. I’m happy retaining full control and keeping costs as low as possible.

However, I do invest in DFA funds through the Utah 529 College Savings plan. A few other 529 plans also offer DFA funds, but I believe Utah has the biggest selection at a reasonable cost. Here are the currently available options:

• DFA Global Equity Portfolio
• DFA Global Allocation 60/40 Portfolio
• DFA Global Allocation 25/75 Portfolio
• DFA Five-Year Global Fixed Income Portfolio
• DFA U.S. Large Cap Value Portfolio
• DFA U.S. Small Cap Value Portfolio
• DFA Real Estate Securities Portfolio
• DFA International Value Portfolio
• DFA One-Year Fixed Income Portfolio

I kept it simple and picked the all-in-one DFA Global Equity fund. I figure, I’ll let DFA take the wheel and see what happens in 20 years. I don’t have to worry about taxes or withdrawals for a long time. As it’s mostly a low-cost index fund at its core, I don’t worry about the downside too much. I just hope Utah does’t change up their fund options down the road and force me into something different.