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VTI: A Good Low Cost U.S. Market ETF For Your Portfolio

Summary Investing can be as simple or as complex as you want to make it. Many investors should start with one well diversified global ETF with a low expense ratio. This article reviews VTI, an ETF that can be added to the core portion of most investors’ portfolios to increase exposure to U.S. market equities. With the strong recent performance of the U.S. market, investors should consider using dollar cost averaging if adding large new investments in U.S. equities to a portfolio. Simply Investing – Philosophy Keep investing simple, consistent, diversified and low cost and you will significantly increase your chance of success. One well diversified global ETF with a low expense ratio is all that is required for many people starting to invest in equities, and an ETF that meets these criteria is the Vanguard Total World Stock ETF (NYSEARCA: VT ). As an investor’s experience, time dedicated to investing activities and desired risk, increases, many investors add ETFs to the core of their portfolio to gain exposure to new areas or increase exposure to areas that the investor believes will outperform. The next step for many investors is to allocate a percentage of their portfolio to “edge” positions, which offer additional risk and opportunity. Vanguard Total Stock Market ETF (NYSEARCA: VTI ) This article reviews VTI, an ETF that can be added effectively to the core portion of most investors’ portfolios to increase exposure to U.S. market equities. VTI – Investment Synopsis VTI’s objective is to track the performance of the CRSP U.S. Total Market Index. VTI invests in large-cap, mid-cap and small-cap equity diversified across growth and value styles. VTI employs a passively managed, index-sampling strategy. VTI five year performance compared to the S&P 500 (click to enlarge) Source: Yahoo Finance (12/14/2015) As the chart above shows, VTI and the S&P 500 have tracked each other very closely over the last five years and both are up approximately 60% over that period. VTI -Equity Characteristics Source: Vanguard (as of 10/31/2015) As the table above indicates, VTI is very diversified, holding 3,797 stocks. The median market cap is very large at $52.1 billion. VTI’s current price/earnings ratio at 21.9 is high compared to historical levels and compared to foreign equities. VTI – Top 10 Holdings Source: Vanguard (as of 10/31/2015) VTI’s top ten holdings are very large, well known, companies and at 15.2% of total net assets, make up a fairly large proportion of the total holdings. VTI – Equity Sector Diversification Source: Vanguard (as of 10/31/2015) VTI’s largest stock holdings are in the financial sector, followed by technology, consumer services and health care. Expenses and dividend yield VTI’s expense ratio is 0.05%, this is well below the average expense ratio of similar funds. Given the relatively high price of the U.S. markets, it is likely that future returns, may be lower than those recently experienced. In this environment, it is important that the core of your portfolio is allocated to funds with low expense ratios like VTI. VTI’s forward looking dividend yield is 1.98% based on the last four quarters distributions. Other U.S. Market ETFs Source: Seeking Alpha (12/14/2015) Above is a list of the top 10 U.S. market ETFs, listed by assets under management (AUM). As indicated, VTI is the third largest U.S. equity fund as measured by assets under management. For those that want to do further research, additional detail on these ETFs is available on Seeking Alpha’s ETF Hub. Conclusion Your chance of long term investment success increases significantly by keeping your investing simple, consistent and well diversified. Most investors would benefit by building a core position in a well diversified global ETF with a low expense ratio like the Vanguard Total World Stock ETF. After establishing this core position, well diversified, low cost, U.S. market ETFs like VTI can increase your exposure to U.S. markets for those investors looking to do so. With the strong recent performance of the U.S. market, investors should consider using dollar cost averaging if adding large new investments to a portfolio.

TIPS ETFs Protect From Inflation Risk, Not Interest Rate Risk

With the Federal Reserve looking to start raising interest rates as soon as next month, investors may be looking for ways to protect their portfolio. While many may look at moving assets into more conservative assets like short term bonds and Treasuries, some will look to Treasury Inflation Protected Securities (TIPS). And that could be a mistake. TIPS work almost just like traditional bonds except that they are indexed to the current rate of inflation. For example, if a $1,000 bond is purchased at par value and the inflation rate is measured at 2%, at the end of the year the principal balance of that bond will be adjusted to $1,020. The higher the inflation rate, the higher the principal balance adjustment. But that’s where the protection ends. Outside of the inflation adjustment, TIPS behave just like any other bond. Shorter term TIPS are generally very conservative investments while longer term TIPS carry a greater degree of volatility. As is the case with any investment that comes with risk, the total value of the investment can potentially lose money over time. All 14 non-leveraged TIPS ETFs that have been around for the last three years have lost money during that time frame. The largest – the iShares TIPS Bond ETF (NYSEARCA: TIP ) – has lost 5.9% during that period. The second largest – the Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ: VTIP ) – has dropped a more modest 2.4%. As would be expected during a period where bond funds have dropped in value, those on the shorter end of the yield curve have fared the best. Those funds targeting a duration in the 3 year or under range have dropped around 3%. Funds with a slightly longer duration have dropped more with the FlexShares iBoxx 5-Year Target Duration TIPS Index ETF (NYSEARCA: TDTF ) down nearly 5%. ETFs with a long term duration or international TIPS exposure have fared the worst of the bunch. The PIMCO 15+ Year U.S. TIPS Index ETF (NYSEARCA: LTPZ ) has fallen more than 10% over the past three years while the iShares International Inflation-Linked Bond ETF (NYSEARCA: ITIP ) has lost over 16%. All of this is to say that TIPS funds and ETFs provide little protection from the effects of interest rate movements. In economic environments like the current one where inflation still remains below the Federal Reserve’s 2% target, TIPS products can underperform. The Vanguard Total Bond Market ETF (NYSEARCA: BND ) has gained almost 5% over the past three years. Inflation risk isn’t the same as interest rate risk. It’s important that investors know the difference.

An ETF Primer

Via Robert Sinche at Amherst Pierpont Securities: Every once in a while a topic, usually the media coverage of a topic, creates a burr in my saddle, as they say. While that has taken place less frequently as I age, the coverage of the ETF market, and particularly the High Yield ETF market, has now reached that level. To be sure, the detailed operation of the ETF market is complicated and I have benefitted significantly from a dialogue with my former colleague and BlackRock Chief FI Investment Strategist Jeff Rosenberg. What I present below, however, are my views and may or may not represent his views. So, there seems to be the view that the creation of ETFs have brought capital into various market segments and, somehow, have added to risk and volatility in those markets. High yield bond ETFs currently are the target of many. But to argue that somehow the money that flowed into ETFs is now creating forced selling and excessive volatility reflects what I think is a lack of understanding on how ETF construction takes place . To be sure, the process IS very complicated and I can understand the misconceptions, and hopefully this note may add some information to the discussion. Jeff forwarded a 2012 paper (pdf attached) by Downing and Lyuee, and for those who want to go through the detailed analysis feel free to do so. What I am more interested in is their excellent discussion of the ETF creation process on pages 3-4. The key quote from the paper is below. As I understand the issue, the selling of ETFs generally only leads to the selling of the underlying assets when there is an arbitrage opportunity for the APs (see below) to buy the ETF and sell the underlying if the price of the ETF falls too far below the NAV of the underlying securities. But it also can work the opposite way – if the underlying securities get too cheap relative to the ETF price, the APs can buy the underlying securities and sell the ETF in the market. It is in this context that ETFs could trade huge volumes at prices set in the open market between buyers and sellers without having to transact ANY underlying securities. In other words, transactions in the underlying securities will take place because of arbitrage opportunities, not simply because investors are selling the ETF . In this context, it does seem to me that ETFs can increase market liquidity and price discovery, not exacerbate the situation in illiquid underlying markets. This is actually different than the open-end MF market – if investors sell their positions in open-end funds the fund company must liquidate underlying securities (unless they already were holding cash positions,), a much bigger problem for the underlying market. Comments/feedback/correction appreciated. Exchange-traded funds (ETFs) are investment vehicles that combine the key features of traditional mutual funds and individual stocks. The typical ETF structure is much like a mutual fund in that shares in the fund represent claims on a portfolio of securities. Typically the ETF portfolio is constructed to track a publicly available index such as the S&P 500. Like stocks, shares in an ETF can be bought or sold (long or short) on an exchange throughout the trading day. This is in contrast to mutual funds, where transactions in shares of the fund occur directly with the fund company at the close of each business day. The pricing mechanism of ETFs relies on the so-called “creation/redemption” process. If an ETF is trading at a price that is higher than the sum of its constituents’ prices, i.e. trading at a premium, the Authorized Participants (APs), which are usually market makers, can purchase the underlying securities and exchange them for shares in the ETF with the ETF manager, and immediately sell the ETF shares on the exchange for a quick profit. This creation mechanism ensures that any premium in ETF pricing is arbitraged away by the APs. The redemption process, which eliminates discounts in ETF pricing, works in the reverse direction. The composition of the basket of securities eligible for creation/redemption is published daily by the ETF manager. In practice, ETF managers may not require that the basket of securities to be exchanged for ETF shares perfectly match the published holdings given the liquidity constraints imposed by the underlying market (i.e., not every bond is trading everyday). The manager may decide to accept a basket where some securities are substituted by similar securities if the substitution would not increase tracking error. One common misconception is that ETFs are “forced sellers” of bonds when markets decline. The rationale behind this view is that, as markets fall and investors sell ETF shares, the ETF portfolio manager will be required to sell securities to fund redemptions. This dynamic does in fact occur with traditional open end mutual funds. While open end mutual funds typically carry a cash reserve to help facilitate redemptions, this reserve may be quickly exhausted during periods of larger outflows, resulting in a sale of securities by the mutual fund portfolio manager. In contrast, ETF investors sell shares of their ETFs on exchange. Whether or not an ETF share redemption ultimately occurs will be driven by the relationship between the exchange market price of the ETF and the actionable value of the underlying redemption basket. If it is economically attractive to exchange shares for bonds, APs will likely seek to do so. At the extreme, if bond markets are impaired, ETF investors may still be able to liquidate their shares on exchange, albeit at a market price that could differ appreciably from the NAV and the ETF’s index (both of which may lag given the limited trading activity in the OTC bond market). In this sense, ETFs do have an additional liquidity venue the exchange which may actually serve to reduce the amount of trading activity in the OTC bond market relative to a traditional open end bond mutual fund. Critics often cite the appearance of anomalous premiums or discounts during periods of market volatility as evidence of dysfunctional behavior in the ETF. However, such behavior often reflects elements of price discovery given the gap in liquidity between the ETF and the underlying bond market [Tucker and Laipply (2012)].