Who among us isn't a fan of the no-muss, no-fuss, either/or decision? Particularly when it comes to financial matters, a good many of us -- myself included -- would love it if we could just find that one perfect retirement-savings vehicle, plunk down a big ol' chunk of change, and lie back in our hammocks and watch the grass -- and our investment -- grow.
Alas, it isn't that way. The perfect portfolio is always a work in progress, one you'll at least need to touch up around the edges as retirement or near-term goals (such as buying a house or funding a child's college education) alter your investment timeline and tolerance for risk.
The good news, though, is that the touching-up process can actually be a lot of fun. And exchange-traded funds (ETFs) can certainly be one of the, um, colors on your investing palette.
They shouldn't be the only one, though.
As with traditional index mutual funds, investing exclusively in ETFs means always having to say you're sorry: Doing so, after all, pretty much condemns you to a lifetime of lagging the market by about the amount of your funds' annual expenses. What's more, while index investing is a time-honored strategy, the fact is, it hasn't worked all that well during certain periods of the market's history. Over the last five years, for example, the typical actively managed domestic-stock fund has bested the S&P 500 by a significant margin.
So, what's a Foolish investor to do? Own both fund flavors, I say.
Doing precisely that is just another layer of intelligent asset allocation, similar to owning both large-cap stocks and small, growth funds and value. It's all about diversification. When one area of the market (or investing style) falls from favor, another will be there to pick up the slack.
You might, for instance, consider splitting your large-cap fund money down the middle and investing half in the Spiders (AMEX:SPY) ETF or in a plain-vanilla S&P tracker such as Vanguard 500 (FUND:VFINX) or Fidelity Spartan (FUND:FSMKX). Meanwhile, you could allocate the other portion to an actively managed fund that fishes more selectively in those same waters.
Indeed, in a recent issue of the Fool's Champion Funds newsletter service -- which you can try for free -- I give the nod to a socially responsible large-cap fund that runs with a svelte portfolio of just 33 stocks. At the end of December 2004, its top holdings included the likes of Liberty Media (NYSE:L), Dell (NASDAQ:DELL), Target (NYSE:TGT), and Comcast (NASDAQ:CMCSK). And you know what? Over the last five years, this fine fund has spanked the S&P by nearly 7 annualized percentage points. It's bested the bogey over the last 10 years, too. Not too shabby, eh?
The bottom line: Don't succumb to the temptation of either/or thinking. ETFs and actively managed funds can coexist peacefully -- and profitably -- in the same portfolio.
This article was originally published on Jan. 14, 2005. It has been updated.
Shannon Zimmerman writes regularly about index funds and ETFs in his Champion Funds newsletter service. Click here to take a free test drive. Shannon doesn't own any of the securities mentioned.
