Exchange-Traded Funds For Dummies
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An exchange-traded fund (ETF) is something of a cross between an index mutual fund and a stock. It’s like a mutual fund but has some key differences you’ll want to be sure you understand. Here, you discover how to get some ETFs into your portfolio, how to choose smart ETFs, and how ETFs differ from mutual funds.

Asking a financial professional about working ETFs into your portfolio

If you’re willing to spend time reading quality resources about exchange-traded funds and portfolio construction, you can create for yourself a portfolio that balances risk and potential return and aims toward your investment goals.

However, many people find that they want at least a bit of guidance from a financial pro before making investment decisions. If that describes you, look for a fee-only financial planner (someone who does not earn commissions on your investments). Here are some questions to ask when you meet that person:

  • Given my personal economics, how much risk should I be taking with my money? Specifically, what percent of my portfolio should be in stock ETFs and what percent in bond ETFs?
  • Given the size of my portfolio, how many individual ETFs would you suggest?
  • Which brokerage house do you recommend for housing my ETF portfolio?
  • What is the historical rate of return on the ETF portfolio that you are suggesting, and just how volatile can it be?
  • Given my age, my tax bracket, and my employment, what kind of account — IRA, Roth IRA, or taxable brokerage account — do you suggest for my ETFs?
  • What selection of ETFs would you advise for an optimally diversified portfolio?
  • Do I keep my present investments, or sell them? If I keep them, how are you going to choose ETFs that best complement those investments?
  • Can you help me juggle the investments in my 401(k) plan to complement my new ETF portfolio?

Choosing the best ETFs

With about 1,300 exchange-traded funds available, where do you start to shop? The answer depends on your objective. If you are looking to round out an existing portfolio of stocks or mutual funds, your ETFs should complement your existing investments. Your goal is always to have a well-diversified collection of investments.

If you are starting to build a portfolio, you want to make sure to include stocks and bonds and to diversify within those two broad asset classes.

There is not much in the world of stocks, bonds, and commodities that can’t be satisfied with ETFs. Keep the following guidelines in mind as you make selections:

  • Mix and match your holdings appropriately.
    You not only want a well-diversified portfolio, but one that includes various asset classes that tend to go up and down in value at different times. There’s no point to holding four different ETFs that all invest in large-cap stocks. Hold a large-cap ETF and a small-cap, a U.S. stock ETF and an international stock ETF.
  • Go for lowest cost.
    As with any other investment vehicle, be careful not to pay more than you need to. Although most ETFs are very economical, some are more economical than others. You may not always want to pick the cheapest, but certainly aim in that direction.
  • Don’t sweat the small stuff.
    Two ETFs that track similar indexes (such as large value stocks, for example) are not going to be all that different from one another. Spend some time researching your options, but don’t agonize over your selection. Much more important — perhaps worth a little agony — is choosing ETFs that track dissimilar indexes so your eggs are in different baskets.
  • Go passive.
    A handful of ETFs promise “active management.” Know that active management has an awfully spotty track record. The bulk, if not all, of your ETF portfolio should be in passively managed (indexed) ETFs.
  • Look for breadth.
    Examine the holdings of the ETF. As a rule, no one security (such as, for example, Microsoft or General Electric stock) should represent more than 10 percent of the ETF’s total assets.

How ETFs differ from mutual funds

At first glance, an exchange-traded fund (ETF) may seem awfully similar to a mutual fund. After all, like ETFs, mutual funds also represent baskets of stocks or bonds. The two, however, are certainly not twins. Maybe not even siblings. Cousins are more like it. Here are some of the significant differences between ETFs and mutual funds:

  • ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their price can change from second to second. Mutual fund orders can be made during the day, but the actual trade doesn’t occur until after the markets close.

  • ETFs tend to represent indexes — entire markets or market segments — and the managers of the ETFs tend to do very little trading of securities in the ETF. (The ETFs are passively managed.)

  • Although they require you to pay small trading fees, ETFs usually wind up costing you much less than a mutual fund because the ongoing management fees are typically much less, and there is never a load (an entrance or exit fee, sometimes an exorbitant one) as there is with some mutual funds.

  • Because of low portfolio turnover and also the way they are structured, investment gains on ETFs usually are taxed more gingerly than the gains on mutual funds.

The following table provides a quick look at some ways that investing in ETFs differs from investing in mutual funds.

ETFs Mutual Funds
Priced, bought, and sold throughout the day? Yes No
Offer some investment diversification? Yes Yes
Is there a minimum investment? No Yes
Purchased through a broker or online brokerage? Yes Yes
Do you pay a fee or commission to make a trade? Often Very rarely
Can you buy/sell
Yes No
Indexed (passively managed)? Typically Atypically
Can you make money or lose money? Yes Yes

About This Article

This article is from the book:

About the book author:

Russell Wild, MBA, an expert on index investing, is a fee-only financial planner and investment advisor and the principal of Global Portfolios. He is the author or coauthor of nearly two dozen nonfiction books.

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