If you’re going to invest in ETFs you have to understand the difference between suitability and credibility. Suitability is when an investment makes sense for you. Such as a young person being invested in aggressive ETFs. Or a retiree being invested in a bond ETF. Those are generally suitable investments for each person. Credibility is the stature of the fund you’re invested in. For example, Vanguard is known in the industry as having excellent ETFs to invest in. When we see a Vanguard ETF in a new client’s portfolio, we know its probably a credible fund.
ETF suitability vs credibility
When we onboard a new client, we often see a lot of different types of investments. Recently, we haven’t seen many red flags from new clients. But one thing we have seen is too many ETFs that don’t make material sense for the specific client. For example, we recently took over a portfolio for a 31-year-old, who had a roughly 5% allocation to the ETF, MUB.
This is an investment-grade municipal bond ETF that offers tax-advantages. But it would also be classified as a conservative investment. In short, it’s a very credible ETF, boasting over $15 billion in AUM. However, it isn’t a very suitable investment choice for this particular client. Specifically, our client had a goal of aggressive growth for his portfolio. So even though he owned a great ETF, it wasn’t an ETF that belonged in his portfolio.
ETFs that do the same thing
Another thing we often see when reviewing new accounts is two ETFs that offer the same benefits. The most common problem this represents is fund overlap, which is when two funds share many of the same holdings. For instance, ITOT is a total US market fund. And it’s a very good one, offering exposure to the entire market spectrum. But, in essence, it acts very similar to VOO, which is an S&P 500 market index ETF. Because of the cap-weighted nature of ITOT, it ends up looking very similar to VOO, even though it owns 6x as many stocks!
In fact, the top 10 holdings for each ETF are the exact same. So even though ITOT is a very good ETF, it doesn’t exactly offer the “total market” exposure you might think it does. And that’s where investors have to be very conscious about how cap-weighted index ETFs impact their overall portfolio. Someone who owns large-cap stocks should not look to ITOT to diversify. Even though ITOT is a very credible fund, it is not suitable for someone who also wants to invest in small caps, for instance.
Should you own it?
There are plenty of good ETFs out there, but it’s not enough to just buy good ETFs and think you’re invested properly. You have to be conscious of if you’re buying the correct ETF and how different ETFs interact with each other. It’s easier than ever before to buy a quality, low-cost ETF and just let it sit in your portfolio. But is that ETF actually one you should own? That’s the question you have to answer when determining the credibility of an ETF vs its specific suitability for your portfolio.
