Exchange-Traded Funds For Dummies
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Maybe you’re intent on staying put with your existing portfolio, but think you can benefit from an occasional ETF holding. You are right and this tells you why and how to reap the benefits of sprinkling a few ETFs into your existing portfolio.

Improve your diversification with ETFs

Unless you are really rich, like Warren Buffett rich, you simply cannot have a truly well-diversified portfolio of individual securities — not nearly as well-diversified as even the simplest ETF or mutual fund portfolio. Where would you even start?

To have a portfolio as well-diversified as even a simple ETF portfolio, you’d have to hold a bevy of large company stocks (both growth and value), small company stocks (again, both growth and value), foreign stocks (Asia and Europe and emerging markets, growth and value, large and small), and real estate investment trust (REIT) stocks. And that’s just on the equity side!

On the fixed-income side of your portfolio, you would ideally have a mix of short-term and long-term bonds, government and corporate issues, and perhaps (especially if you are Warren Buffett rich and find yourself in the northern tax brackets) some federal-tax-free municipal bonds.

Examine your portfolio. If you have the large majority of your equity holdings in large company U.S. stocks, you can diversify in a flash by adding a small cap ETF or two and a couple of international ETFs. If you, like so many investors who lost their shirts in 2008, are simply too heavily invested in stocks, you may want to tap into some of the more sedate bond ETFs.

Minimizing your investment costs

Now, let’s assume you’re basically a mutual fund kind of guy or gal. You’ve been reading Money magazine and Kiplinger’s for years. You believe that you have winnowed down the universe of mutual funds to a handful of winners, and goshdarnit, you’re going to keep them in your portfolio.

You may or may not have heard the terms core and satellite. They refer to an investment strategy that has been very much in vogue lately. Core refers to a portfolio’s foundation, which is basically invested in the entire market, or close to it. Then, you have your satellites: smaller investments designed to outdo the market. It isn’t such a bad strategy.

Suppose you have four mutual funds that you love: one tech fund, one healthcare fund, one energy fund, and one international growth fund. Each charges you a yearly fee of 1.34 percent (the mutual fund average right now, according to Morningstar).

Now suppose you have $250,000 invested in all four. You are paying ($250,000 × 1.34 percent) a total of $3,350 a year in management fees, and that’s to say nothing of any taxes you’re paying on dividends and capital gains.

Consider trimming those investments down and moving half the money into an ETF or two or three. Turn your present core into satellites, and create a new core using broad-market funds, such as the Vanguard Total Stock Market ETF (VTI). It carries an expense ratio of 0.07 percent.

Your total management fees are now ($125,000 × 1.34 percent) + ($125,000 × 0.07 percent), or $1,675.00 + $87.50, which totals $1,762.50. You’ve just saved yourself a very nifty $1,587.50 a year, and you’ll likely save a considerable amount on taxes, too.

With the newer generation of actively managed ETFs, it’s quite possible that the Kiplinger’s or Money or Wise Money or whatever magazine picks-of-the-month may include ETFs. If you are swapping actively managed mutual funds for actively managed ETFs, you may still save money and lower your tax hit to boot.

About This Article

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About the book author:

Russell Wild is a NAPFA certified financial advisor and principal of Global Portfolios, an investment advisory firm based in Allentown, PA that works with clients of both substantial and modest means. He has written two dozen books and numerous articles on financial matters.

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