The Little Book of Common Sense Investing, Updated and Revised

Chapter FifteenThe Exchange-Traded Fund (ETF)

A Trader to the Cause?

DURING THE PAST DECADE, the principles of the traditional index fund (TIF) have been challenged by a sort of wolf in sheep’s clothing, the exchange-traded fund (ETF). Simply put, the ETF is an index fund designed to facilitate trading in its shares, dressed in the guise of the traditional index fund.

If long-term investment was the paradigm for the original TIF designed 42 years ago, surely using index funds as trading vehicles can only be described as short-term speculation. If the broadest possible diversification was the original paradigm, surely holding discrete—even widely diversified—sectors of the market offers far less diversification and commensurately more risk. If the original paradigm was minimal cost, then this is obviated by holding market-sector index funds that carry higher costs, entail brokerage commissions when they are traded, and incur tax burdens if one has the good fortune to trade successfully.

But let me be clear. There is nothing wrong with investing in those indexed ETFs that track the broad stock market, just so long as you don’t trade them. While short-term speculation is a loser’s game, long-term investment is a proven strategy, one that broad market index funds are well positioned to implement.

ETF traders have absolutely no idea what relationship their investment returns will bear to the returns earned in the stock market.

The quintessential aspect of the original paradigm ...