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You’re right if you guessed that the largest stock fund is an exchange-traded fund (ETF), a fact I always find somewhat surprising when studying the list of the largest stock funds in The WSJ’s monthly fund report. The one at the top of the list is the SPDR S&P 500 ETF (SPY), with $91.11 billion in assets.

When I first started working in this industry, back in 1995, Fidelity Magellan was the largest stock fund. It was an actively managed fund, so it was a big deal when it was surpassed by Vanguard’s Index 500, a passive index fund. With the index fund, investors knew what they owned, liked its simplicity, and loved its low costs. Is the dominance of mutual funds now threatened by the emergence of ETFs? I think so.

It’s too early to tell when this will happen. Mutual funds still far outweigh ETFs in assets under management. The Investment Company Institute (ICI) reported that mutual funds had $9.6 trillion under management at year-end 2008 while ETFs had $531 billion. However, the trend has consistently shown this gap shrinking. In fact, ETFs’ share of total fund assets grew from 3.9% in 2005 to 7.2% in November 2009.

The emergence of ETFs may be both good and bad news. It’s good because more investment choices make it easier to narrow in on a specific area of the market, costs are low, and liquidity is improved. It’s bad because investment selection isn’t easier now that both ETFs and mutual funds exist. With over 9,000 options to choose from between the two, where do you start?

At our family investment company, one ETF we’ve been buying regularly is SPDR Gold Trust (GLD)—the world’s largest physically backed gold ETF. GLD is a straight bullion play and blends in well with our other ETF, mutual fund, stock, and bond selections.

The current landscape for bonds is ugly. Three-month Treasury bills offer 0.09%. The 5-, 10-, and 30-year Treasury bonds offer 2.24%, 3.57%, and 4.52%, respectively. For those of you looking for yield, duration has never been more important—especially if you’re retired or soon to be retired.

Bond ETFs don’t meet our criteria. We recommend short-term bond funds and/or a laddered corporate bond portfolio. A bond ladder staggers several bonds with differing maturities. Taken as a group, they have an average maturity. When interest rates go up, the prices of the bonds go down. Don’t panic. Patiently collect interest and hold until maturity when principal is returned. With the cash proceeds, invest back into the bond ladder at a point that keeps the duration comfortable for you.

Simply stated, duration is the change in a bond’s market value when interest rates go up or down by 1%. For example, the value of a bond portfolio with a duration of three years will decline by approximately 3% if interest rates go up by 1%. Similarly, Treasury bonds with a duration of 25 years will decline by approximately 25% of their value if rates go up by 1%. That’s the maturity risk when reaching too far for yield.

Managers at pension funds are taking on additional risk to meet their funding needs. Executives at the State of Wisconsin Investment Board (SWIB), which oversees the 28th-largest pension fund, requested and received approval by the board last month to use borrowed money to boost performance. They will be able to borrow up to 120% by 2012.

Now that the flood gates are open, who’s to say they won’t request more leverage down the road? As reported in SmartMoney magazine, “[T]o properly position pension funds for a variety of economic conditions while achieving the rate of return assumed for actuarial purposes, fund managers would need to invest at least 200% of assets.” Losing 50% wipes out the entire pension plan. That could never happen, right?

The average public pension fund expects between 7.5% and 8% return per year. Do they really think this is sustainable? How about reducing expected annual rates of return? Not likely. That would mean going to taxpayers to bridge the unfunded liability gap. Executives could lose their jobs if the taxpayers get angry. Can you imagine the dialogue in these meetings? I wonder if the executives at SWIB would take this risk with their own money.

ETFs and leverage are just two examples of the gradual shift in today’s investment landscape. Instituting leverage doesn’t require much skill. But in a down market, having a manager who can calmly navigate among the right ETFs, mutual funds, stocks, and bonds does.

E.J. Smith is Managing Director of Richard C. Young & Co., Ltd. an investment advisory firm managing portfolios for investors with over $1,000,000 in investable assets.

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E.J. Smith

Editor-in-Chief
E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@youngresearch.com.