In support of indexing

I already wrote about that I support indexing. Here is more information about indexing compared to some other types of investments.  

There are many advantages of indexing. The two main advantages for me are the diversification and the inability to go down to $0 like individual stocks. Those two features appear to be protective in bear markets. 
Of course like individual stock the indexes will go down during depression times too but their come back up is more certain. For the broad market ETFs that works even better than for market sector ETFs.

Below I will compare index ETFs to actively managed ETFs and to individual stocks.



Tax efficiency
The turnover rate in index ETFs is lower compared to actively managed ETFs and that will generate fewer capital gains. If you buy individual stocks it will depend on how long you hold that stock. Different indexes have different turnover rates too and even using only index ETFs may still produce some capital gains.

Costs
First there are transaction costs (commissions) - costs of buying or selling stock or ETF. Those comissions are the same for both types of investments.  Some institutions offer commission free ETFs, for example E-Trade, Fidelity, Schwab and others offer commission free ETFs. I noticed that that is not always the best deal. Some ETFs will have large spreads (difference between sell and buy price) and if buying or selling a large position the amount you lose due to spread will be much more than a commission if you trade an ETF with a tight spread. The spread will be less important if the amount is small or if you plan to hold for a very long time.
 
Example:
A commission free ETF with a bid/ask spread of 10 cents. 
If you buy 500 shares, the "costs" due to spread will be $50. That means you will be immediately in minus of $50 and will have additional $50 to cover before getting into the green.

An ETF with a spread of 1 cent plus commissions.
If you buy 500 shares, the "costs" due to spread will be $5. The commissions are the additional $4-5. You will be down only $10.
The larger the position, the larger will be amount lost due to spread.
The worst case would be to trade ETFs or stocks with large spreads with a broker who charges high commissions.
The best case would be to trade a narrow spread ETFs or stocks with a low commission broker or to avoid commissions.  
And don't forget the expense ratio for ETFs. 

Stocks will have costs associated with every transaction of buying or selling but there is no cost for holding it.
The ETFs have expense ratios and in addition to the transaction costs there will be holding costs for the period you hold the ETF. The ratios vary a lot and can be very low, for example 0.03% for SCHB (broad market ETF from Schwab) and 9.26% for BIZD (VanEck Vectors BDC Income ETF). 

   
Diversification
The index ETFs do have built in diversification compared to a single stock.
The degree of the diversification depends on the structure of a particular ETF.
For example S&P500 is tracking 500 stocks and the Russel2000 is tracking 2000 stocks. Some of the stock held by different indexes overlap, for example the Apple stock is held by both SPY and QQQ.  
The stocks may be represented differently in an ETF. There equal weighted ETFs and non-equal weighted ETFs. You can read more about the difference between them in this post.
If you want to diversify your investments well with just stocks, that will definitely require more work.   


Risk control
Two risks are controlled with ETFs:
1. The risk of losing a substantial amount of money due to bankruptcy of a company which stock becomes worthless or falls very low and never recovers. The major indexes always recover even after severe depression.
2. Indexing eliminates the risk of mismanagement of your money by an active manager who can make wrong decisions which will lead your fund to underperform the market. Index tracking ETFs will market-perform.  
  

 

Equal weighted ETFs - better or worse than regular index ETFs?

What are equal weighted index finds?

If you look at the components of an index fund such as S&P500, you will see that large companies are overrepresented. Even if  the index holds 500 companies they are not equally represented.

As you see below in the example of SPY ETF which tracks S&P 500 index, Apple comprises 3.94% of the index and the top 10 holdings represent not 10% but 20% of the index.

Here is the example of QQQ and Apple stock is also overrepresented. The top 10 holdings represent over 50% of the ETF value.  

An equal weighted index fund will hold the same set of companies as its underlying index but the value amount be equally distributed.  

RSP is the equal weighted ETF corresponding to SPY and QQQE is the equal weighted ETF corresponding to QQQ.
The expense ratios are higher due to higher turnover and the equal weighted ETFs may produce more capital gain distributions. But are they a better choice for the investor?

The non-equal weighted indexes are weighted by market capitalization. When a stock is increasing in price, the index will increase the amount of stock that is going up. If the stock goes down, the index will decrease the amount of stock held. Basically it is going with the trend.

The equal weighted indexes are more contrarian. The funds are divided equally between all held stocks. If a stock goes down in price, it will be bought and the opposite with the rising in price stocks - they will be sold to keep the equal shares.
This will lead to sell high and buy low. It also may lead to keep buying a stock which will never get up again. But since one possible big loser stock will only be 1/500 the risk is contained. During the recession when the stock prices are going down, more stocks will be bought at a lower price  buy the equal weighted ETFs compared to the non-equal weighted ETFs.

How did their performance compared during last recession? 
 
Here is SPY compared to RSP. This timeframe includes year 2009.

However in the last 5 years there is no significant difference in performance.  
 

 

And in the last year the non-equal weighted SPY outperformed the equal weighted RSP.

 

Now let's compare QQQ and QQQE. In this case the non-weighted QQQ over performed the equal-weighted QQQE in the long term.

The same for the last 5 years:

And for the last year:

Whatever the explanation is, the results are variable.

The expense ratios for equal weighted ETFs are higher (SPY 0.09%, RSP 0.20%, QQQ 0.20% and QQQE 0.35%).

The main advantage of the equal weighted ETFs appears to be in the diversification - they are more diversified compared to the non-weighted ETFs.