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Russell Wild
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Published:
October 26, 2015

Investing in ETFs For Dummies

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Overview

Develop ETF expertise with this straightforward guide

Investing in ETFs For Dummies has all the basics you need to make calculated and profitable choices when investing in exchange-traded funds. ETFs make it possible for investors to quickly and easily gain exposure to wide swaths of the market. There are funds that are linked to popular market indices like the S&P 500, there are quirky thematic funds that allow you to invest in stuff like video game technology or breakfast commodities, and there’s everything in between. This updated guide helps you sift through it all, covering the pros and cons of ETF investing and walking you through new and time-tested ETF strategies. Add some ETFs to your portfolio and profit in any market environment, thanks to this simple Dummies guide.

  • Figure out what ETFs are and learn the ins and outs of the ETF marketplace
  • Learn to research ETFs and weigh the risks so you can make informed trades
  • Discover the latest ETF products, providers, and strategies
  • Gain the confidence you need to invest in ETFs, even in a down market

Investing in ETFs For Dummies is a great starting point for anyone looking to enhance their investment portfolio by participating in the nearly $2 trillion ETF market.

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About The Author

RUSSELL WILD advises clients in retirement planning and global portfolio diversification through the use of fund management. He has written nearly two dozen books on financial topics.

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An exchange-traded fund (ETF) is something of a cross between an index mutual fund and a stock. Because ETFs are relatively new to investors, they have a lot of questions. Are ETFs appropriate for individual investors? You bet they are. Although the name exchange-traded funds sounds highly technical and maybe a little bit scary, ETFs are essentially friendly index mutual funds with a few spicy perks.
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If you have a portfolio of more than $20,000 and you are a buy-and-hold kind of guy or gal, break up your small cap holdings into a growth exchange-traded fund (ETF) and a value ETF. Given the dramatic outperformance of value in the past, you might tilt in that direction — more so than you do with large caps. A reasonable tilt may call for somewhere between 60 and 75 of your small cap exposure going to value, and 25 to 40 percent going to growth.
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Investing in ETFs differs from investing in mutual funds and individual stocks in some important ways, as the following table shows. As a smart investor, you can't ignore the advantages that ETFs offer. ETFs Versus Mutual Funds Versus Individual Stocks ETFs Mutual Funds Individual Stocks Priced, bought, and sold throughout the day?
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Of late, a number of exchange-traded funds (ETFs) have cropped up to allow you to invest in so-called frontier markets, including the PowerShares MENA Frontier Countries Portfolio (PMNA), the Guggenheim Frontier Markets ETF (FRN), and the Market Vectors Gulf States ETF (MES). These markets feature economies even smaller, stock markets even newer and potentially less regulated, and governments perhaps even shakier than in emerging market nations.
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Exchange-traded funds (ETFs) were brought into being by marketing people from the Toronto Stock Exchange who saw a way to beef up trading volume. Unlike mutual funds, which can be bought and sold only at day's end, ETFs trade throughout the day. In a flash, you can plunk a million in the stock market. A few seconds later, you can sell it all.
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Whatever your total allocation to domestic small cap stocks, anywhere from 60 to 75 percent of that amount should be allocated to small value. But no more than that, please. If the value premium disappears or becomes a value discount, you don't want to be left holding the bag. And even if small value continues to outperform, having both small value and small growth (along with their bigger cousins, all of which tend to rise and fall in different cycles) will help smooth out some of the inevitable volatility of holding stocks.
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After you decide which industry sectors you wish to invest in, you need to pick and choose among exchange-traded funds (ETFs). Blackrock's iShares offers about 40 U.S. selections and 40 global or international selections. PowerShares has about 50 domestic and a dozen international sector funds. State Street Global Advisors offers about two dozen SPDRs that cover U.
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A bit of growth, a bit of value, your choice in small cap blend funds should take into consideration such things as expense ratios, average cap size, and P/E ratio. Keep in mind that these numbers are subject to change, so check them before you act. Some good ETF options for people with limited-size portfolios include the Vanguard Small Cap (VB), iShares Morningstar Small Core (JKJ), iShares S&P Small Cap 600 (IJR), and Schwab U.
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What role, if any, should small cap growth stocks play in your ETF portfolio? The following figure shows where you can see how small growth fits into an investment style grid. The shaded area is the portion of the investment grid represented by small growth stocks. In the past century, small cap stocks have outperformed large cap stocks just as assuredly as Honduras has produced more Hondurans than the United States.
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The broadest fixed income ETFs are all-around good bets, especially for more modest sized portfolios. Note that these bonds use a total (taxable) bond market approach, which means about two-thirds government bonds and one-third corporate (no municipal). These funds also make the most sense for investors with lots of room in their tax-advantaged retirement accounts.
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There's no point to having dozens of exchange-traded funds (ETFs) in your portfolio if they are only going to duplicate each other's holdings. So if you already own the entire market through diversified ETFs in all corner quadrants of the style grid — large, small, value, and growth — why add any industry sectors that are obviously already represented?
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Don't let "small value" fool you. If you can stomach a bit of risk, these stocks can more than pull their weight. Consult history. See the following figure, which shows where small value fits into the investment style grid. Small value stocks are important in a poised-for-performance ETF portfolio. Small value stocks occupy the southwest corner of the investment style grid.
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Until recently, all ETFs were index funds. And in the past few years, most index funds have been ETFs. On March 25, 2008, Bear Stearns introduced an actively managed ETF: the Current Yield ETF (YYY). As fate would have it, Bear Stearns was just about to go under, and when it did, the first actively managed ETF went with it.
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Just as you may need a new suit if you lose or gain weight, sometimes you need to tailor your portfolio in response to changes in your life. Rebalancing your portfolio, making tactical adjustments, and harvesting losses for tax purposes aren't the only times it may make sense to trade exchange-traded funds (ETFs).
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Increasingly, individuals and institutions are investing using some kind of moral compass. The investments are screened not only for potential profitability but for social, environmental, and even biblical factors as well. Some screens, for example, attempt to eliminate all companies that profit from tobacco or weapons of mass destruction.
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Investment legend Benjamin Graham liked to use something called the P/E ratio. The P stands for price; the E stands for earnings. When the market price of a stock (or all stocks) is high, and the earnings (or profits for a company or companies) are low, then you have a high P/E ratio; conversely, when the market price is down but earnings are up, you have a low P/E ratio.
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Slow-growing economies (such as India's, whose stock market has lately left China's in the dust) generally make for better stock investments! You would think that a fast-growing economy would be the best of places to invest. And yet there is more to stock returns than the growth of a national economy. (Just ask those investors who poured money into China several years ago.
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What is the difference between an ETF and a mutual fund? After all, mutual funds also represent baskets of stocks or bonds. The two, however, are not twins. They're not even siblings. Cousins are more like it. Here are some of the big 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 prices change throughout the trading day.
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Some holders of Real Estate Investment Trusts (REITs) and REIT funds believe (and fervently hope) that such performance will continue. Others argue that the glory of REITs may already be gone with the wind. Here are several reasons why REITs deserve a permanent allocation in most portfolios. Limited correlation to the broad markets An index of U.
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If you wish to dampen the volatility of your foreign stock holdings, you can opt to own funds that specifically eliminate or "hedge" against currently flux. This may not be a bad idea if you are especially risk-averse and if you are heavily invested overseas. But know that hedging will cost you. WisdomTree Investments currently has a lineup of 14 currency-hedging ETFs, such as the WisdomTree Europe Hedged Equity ETF (HEDJ) and the WisdomTree Europe Small-Cap Hedged Equity ETF (EUSC).
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The oldest and largest of the ETF dividend funds is the iShares Dow Jones Select Dividend Index Fund (DVY). For U.S. domestic investments, here are some other options: SPDR Dividend ETF (SDY) Vanguard Dividend Appreciation ETF (VIG) First Trust Morningstar Dividend Leaders Index Fund (FDL) PowerShares Dividend Achievers Portfolio (PFM) PowerShares High Yield Equity Dividend Achievers Portfolio (PEY) Why two PowerShares domestic dividend ETFs?
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