Exchange-Traded Funds For Dummies
Overview
Become an ETF expert with this up-to-date investment guide
Want to expand your portfolio beyond stocks and mutual funds? (Of course you do, you smart investor you.) Then take a look at exchange-traded funds (ETFs)! A cross between an index fund and a stock, they're transparent, easy to trade, and tax-efficient. They're also enticing because they consist of a bundle of assets (such as an index, sector, or commodity), so diversifying your portfolio is easy. You might have even seen them offered in your 401(k) or 529 college plan.
Exchange-Traded Funds For Dummies is your primer on ETFs. It gives you an insider (the legal kind!) perspective on the investment process, starting with an overview of ETFs and how they differ from stocks and mutual funds. The book also helps you measure risk and add on to your portfolio, and offers advice on how to avoid the mistakes even professionals sometimes make. Throughout, you'll also find plenty of tips, tricks, and even sample portfolios to set you up on the right path for investment success.
With Exchange-Traded Funds For Dummies, you will:
- Find out exactly what exchange-traded funds are and why they make good investments
- Mix and match stock portfolios to diversify yours
- Go beyond stocks for maximum diversification: bonds, real estate, and commodity ETFs
- Maintain your portfolio for future growth
With the tricks of the trade in Exchange-Traded Funds For Dummies, you can easily apply the knowledge you gain to turn good investments into great ones. Happy earning!
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About The Author
Russell Wild, MBA, is the author or coauthor of nearly two dozen books, including Index Investing For Dummies and Bond Investing For Dummies. He has a master’s degree in business administration and a graduate certificate in personal financial planning. Wild is also an associate of NAPFA.
Sample Chapters
exchange-traded funds for dummies
CHEAT SHEET
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.
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Funds
The two oldest and most popular ETFs that use social screens are as different as night and day. The iShares MSCI USA ESG Select Index ETF (KLD) is a broad-based large cap blend (both value and growth) fund. The PowerShares WilderHill Clean Energy Fund (PBW) is a narrow industry sector fund and a small growth style fund and a bit global with approximately 25 percent of the holdings being non-U.
Exchange-traded funds (ETFs) were first embraced by institutions, and they continue to be used big-time by banks and insurance companies and such. Institutions sometimes buy and hold ETFs, but they are also constantly buying and selling ETFs and options on ETFs for various purposes.
For noninstitutional types, the creation and expansion of ETFs has allowed for similar juggling (usually a mistake for individuals); but more importantly, ETFs allow for the construction of portfolios possessing institutional-like sleekness and economy.
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The broadest fixed income ETFs are all-around good bets, especially for more modest sized portfolios. Note that these bond ETFs use a total bond market approach, which means about two-thirds government bonds and one-third corporate.
These funds also make the most sense for investors with lots of room in their tax-advantaged retirement accounts.
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Even the laziest investor in ETFs has to make choices: Do you want worldwide exposure to stocks only? Or to stocks and bonds? Do you want the allocation between stocks and bonds to remain the same for the life of your investment? Or do you want that allocation to adjust as you get closer to retirement?
Buy into global ETFs
If you want instant exposure to the broadest possible index of stocks, including U.
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The management companies that manage exchange-traded funds (ETFs), such as BlackRock, Inc. and Invesco PowerShares, are presumably not doing so for their health. No, they’re making a good profit. One reason they can offer ETFs so cheaply compared to mutual funds is that their expenses are much less.
When you buy an ETF, you go through a brokerage house, not BlackRock or Invesco PowerShares.
That all depends. Some ETFs are way riskier than others. It all comes down to a question of what kind of ETF we’re talking about.
Most ETFs track stock indexes, and some of those stock indexes can be extremely volatile, such as individual sectors of the U.S. economy (technology, energy, defense and aerospace, and so on) or the stock markets of emerging-market nations.
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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.
Buying and selling an exchange-traded fund (ETF) is just like buying and selling a stock; there really is no difference. Although you can trade in all sorts of ways, the vast majority of trades fall into these categories:
Market order: This is as simple as it gets. You place an order with your broker or online to buy, say, 100 shares of a certain ETF.
With 222 ETFs for sale and $475 billion in ETF assets (about 45 percent of the U.S. ETF market), iShares is the undisputed market leader. The firm behind iShares, BlackRock, Inc., merged in 2009 with Barclays Global Investors, the mega-corporation that is now one of the largest investment banks in the world ($3.
BlackRock, Inc. offers U.S. sector funds along with international and global sector funds through its iShares line of ETFs. The iShares industry sector offerings include the following:
U.S. Sector Fund Name Ticker
iShares Dow Jones U.S. Basic Materials Index
IYM
iShares Dow Jones U.S. Consumer Goods Index
IYK
iShares Dow Jones U.
Corporate bonds typically pay higher rates than government bonds (about 1 percent a year higher), so you would expect the long-term payout from this ETF to be higher than any government bond ETF, except perhaps for the longest of the long-term government bond ETFs.
In the area of corporate bonds, credit ratings are essential.
There are about 150 bond ETFs, most of them introduced in the past five years. They are issued by iShares, Market Vectors, PIMCO, PowerShares, State Street SPDRs, Vanguard, iPath, Guggenheim, and WisdomTree.
The U.S. Securities and Exchange Commission is sitting on applications for many other fixed-income ETFs, including a dozen or so additional funds from PIMCO (a mutual fund company famous for its bond management) and another two dozen or so from State Street SPDRs.
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Although emerging market bond ETFs have been around for only a few years, emerging-market bond mutual funds have been in existence for much longer. The T. Rowe Price Emerging Markets Bond Fund (PREMX), for example, has a 15-year average annual return of 11.45 percent. But there has been volatility, for sure: In 2008, the fund lost nearly 18 percent of its value.
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If you allocate roughly half your equities to overseas ETFs in your stock portfolio, you’ll have plenty of exposure to foreign currencies. But still, if you have a fairly large portfolio and half or more of it is in bonds, allocating perhaps 10 to 25 percent of your bonds to overseas ETFs would enhance the benefits you can achieve from diversification.
Either the iShares Barclays TIPS Bond Fund ETF (TIP) or the very similar SPDR Barclays Capital TIPS ETF (IPE) is a fabulous way to hedge your bond portfolio against inflation.
Technically, U.S. Treasury Inflation-Protected Securities (TIPS) are Treasurys, but they are usually referred to as TIPS. They play a distinctly different role in your portfolio.
Low costs are even more essential in picking a bond ETF than they are in picking a stock ETF. When (historically, at least over the past century) you’re looking at maybe earning 2.4 percent above inflation, paying a manager even 1.2 percent a year is going to cut your profits in half . . . more than half if you are paying taxes on the bond dividends.
There are a few national municipal ETFs — that is, funds that hold state and local government bonds from across the land — that are worthy of consideration for your portfolio.
If you live in a state with high income taxes, such as New York or California, and you’re in a high tax bracket, you may want to investigate state-specific muni mutual funds; plenty of them are out there (try Vanguard, T.
Like stocks, bonds can be bought individually, or you can invest in any of hundreds of bond mutual funds or about 150 bond ETFs. The primary reason for picking a bond fund over individual bonds is the same reason you might pick a stock fund over individual stocks: diversification.
Sure, you have to pay to get your bonds in fund form, but the management fees on bond ETFs tend to be very low.
Treasury bond ETFs come in short-term, intermediate-term, and long-term varieties, depending on the average maturity date of the bonds in the ETF’s portfolio. In general, the longer the term, the higher the interest rate but the greater the volatility.
Note that interest paid on Treasurys (yeah, that’s how they’re typically spelled) — including Treasury ETFs — is federally taxable but not taxed by the states.
To be honest, diversification in bond ETFs, while important, isn’t quite as crucial as diversification in stock ETFs. If you own high-quality U.S. government bonds (as long as they aren’t terribly long-term) and you own a bevy of bonds from the most financially secure corporations, you are very unlikely to lose a whole lot of your principal, as you can with any stock.
If you are going to hold a portion of your investment portfolio in bond ETFs, you will need to have some knowledge of bond ratings.
In August 2011, the credit rating agency Standard & Poor’s (S&P) downgraded U.S. Treasury bonds from the highest rating (AAA) to a smidgeon below (AA+). Other bond raters did not follow suit.
If you decide that you want to be a socially responsible investor, you have many choices: About 110 mutual funds and two dozen ETFs now invest with some social screen. The growing number of ETFs designed to appeal to your conscience spans the spectrum from U.S. to foreign to global (foreign and U.S. combined).
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.
Innovation is a great thing. Usually. In the world of exchange-traded funds (ETFs), a few big players (BlackRock, State Street Global Advisors, Vanguard) jumped in early when the going was hot.
Now, in order to get their share of the pie, a number of new players have entered the fray with some pretty wild ETFs.
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If you want direct commodity exposure in your investment portfolio, consider that a number of the newest ETFs and ETNs are promising to deal with some of the problems of the first-generation commodity funds.
The leader in this brigade is iPath, which in April 2011 introduced a new lineup of ETNs called Pure Beta indexes.
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When, in November 2004, State Street Global Advisors introduced the first gold ETF, it was a truly revolutionary moment. You buy a share just as you would buy a share of any other security, and each share gives you an ownership interest in one-tenth of an ounce of gold held by the fund.
Yes, the gold is actually held in various bank vaults.
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This introduces you to ETFs that let you invest in the stocks of companies in the oil and gas sector, in mining, and in the broader category of “natural resources” or “materials.” Do your research, but these picks give you a good starting place.
Oil and gas ETFs
More than a dozen ETFs allow you to invest in the stocks of oil and gas companies.
ETF investor should use much caution before investing in commodities, especially in funds that use futures and other derivatives. The explanation for lies in something called contango. That’s a word that nearly all investors in commodity ETFs, at least those that rely on futures contracts, wish to heck they never heard.
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The United States Oil Fund (USO) opened on the American Stock Exchange on April 10, 2006. Even though the fund is technically not an ETF but a very close cousin called a commodity pool, that date marks a sort of end to the Age of Innocence for ETFs. The United States Oil Fund, as official as that sounds, is run by a group called Victoria Bay Asset Management.
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In April 2006, the iShares Silver Trust (SLV) ETF was introduced. When you buy a share of SLV, you obtain virtual ownership of 10 ounces of silver. But, to say that silver is volatile is a gross understatement.
Silver is a volatile investment (thus so are silver ETFs)
In 1979, the price of an ounce of silver was about $5.
Some of the many advantages of exchange-traded funds (ETFs) include low costs, tax efficiency, transparency (you know what you’re buying), and the long track record of success for indexed investments.
In the world of actively managed mutual funds (which is to say most mutual funds), the average annual management fee, according to Morningstar, is 1.
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On the face of it, dividends look like free money from your ETF investments. But nothing in life is quite so simple. Here are some of the things to be aware of when considering purchasing dividend stocks:
Dividend stocks won’t necessarily increase your overall holdings. Suppose you own an individual share of stock in a company that issues a dividend of $1.
The idea behind high dividend mutual funds and ETFs is simple enough: They attempt to cobble together the stocks of companies that are issuing high dividends, have high dividend growth rates, or promise future high dividends.
The oldest and largest of the ETF dividend funds is the iShares Dow Jones Select Dividend Index Fund (DVY).
On the plus side of exchange-traded funds (ETFs) there are ultra-low management expenses, super tax efficiency, transparency, and a lot of fancy trading opportunities, such as shorting, if you are so inclined. What about the negatives?
ETF trade commissions
You may have to pay a commission every time you buy and sell an ETF.
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Whether or not you need a financial professional to set up and monitor your ETF portfolio depends on both your particular skills and your inclination to spend a Sunday afternoon getting greasy under the hood. Setting up a decent ETF portfolio is very doable. You can certainly monitor such a portfolio, as well.
It is possible to buy stocks and exchange-traded funds (ETFs) on margin. “Buying on margin” means that the brokerage house is lending you money, and charging you interest, so you can purchase securities. Ouch.
One of the often touted “advantages” of ETFs is that you can buy them on margin — something you often can’t do with mutual funds.
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Exchange-traded notes (ETNs) sure sound like exchange-traded funds, and the two do have some things in common. But they also have one or two big differences. The commonalities include not only their names but the fact that both ETFs and ETNs trade throughout the day, they both tend to track indexes, and they both can be tax efficient — especially the ETNs.
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Two brokerage houses that house exchange-traded funds (ETFs), along with other stock options, competitively are Fidelity Investments and Charles Schwab. Both have their own ETFs and allow you to house ETFs from other companies as well.
Fidelity Investments
The service at Fidelity is fabulous. The cost of trading at Fidelity is very competitive.
Vanguard is also both an investment house that serves as a custodian of exchange-traded funds (ETFs) and is itself a provider of ETFs. (That’s also true of Schwab and soon will be true of T. Rowe Price, too.) There’s also “The Vanguard edge” (the ability to convert Vanguard mutual fund to an ETF that tracks the same index without tax ramifications).
Why, you may ask, do you need European and Japanese stocks in your ETFs when you already have all the lovely diversification: large, small, value, and growth stocks, and a good mix of industries? The answer, mon ami, mi amigo, is quite simple: You get better diversification when you diversify across borders.
Suppose you have a wad of money invested in the iShares S&P 500 Growth Index fund (IVW), and you want to diversify:
If you combine IVW with its large value counterpart, the iShares S&P 500 Value Index Fund (IVE), you find that your two investments have a five-year correlation of 0.
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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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Search “Market timing success” and you’ll see websites and newsletters offering you all kinds of advice that’s sure to make you rich. Add “ETF” to your search, and you’ll quickly see that an entire cottage industry has formed to sell advice to wannabe ETF day-traders.
According to these websites and newsletters, following their advice has yielded phenomenal returns in the past (and they’ll give you specific BIG numbers proving it).
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Imagine a hypothetical daily pricing pattern for a hypothetical ETF that we will give the hypothetical ticker symbol UGH. What you see at point A is a major reversal pattern known to technical analysts as the “Head-and-Shoulders.” Notice that as the price dips below the “Neckline” and then rises with simultaneous “Increased Volume” that the “Reversal” of the “Trend” begins to manifest.
Value Line — a purveyor of market-timing and stock-picking advice — not only offers advice on picking ETFs as well as stocks, but also they had their own ETF until recently — the Value Line Timeliness Selection ETF — that actually mirrored the advice given by the famed Value Line newsletter. The fund was administered by PowerShares, which pulled the plug on it after four years of lackluster returns.
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Achieving riches with ETFs is only the latest gimmick of investment websites and newsletters that are part of a phenomenon that financial journalist Jane Bryant Quinn once called “investment pornography.” Many newsletters, magazines, newspaper columns, books, and television shows exist to titillate and tease you with the promise of riches.
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Inflation and expectations of market returns can influence your portfolio negatively if you forget to take them into account. When building your ETF portfolio and planning your financial future, take care that you remember to consider these two factors.
Unrealistic expectations of market returns
One reason many people don’t save enough is that they have unrealistic expectations; they believe fervently that they are going to win the lottery or (next best thing) earn 25 percent a year on their investments.
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Times change; circumstances change. Your investment portfolio with its ETFs, mutual funds, and individual stocks and bonds needs to keep up with the times.
Suppose you are 45 years old and saving for retirement. Using the 20x rule, you decide that your goal is someday to have a portfolio worth $1.0 million. Your current portfolio has $300,000, so you have a good ways to go.
When you invest in anything, be it exchange traded funds (ETFs), mutual funds, or individual stocks and bonds, there’s always a bit of a gamble involved. (Even when you decide not to invest, by, say, keeping all your money in cash, stuffed under the proverbial mattress, you’re gambling that inflation won’t eat it away or a house fire won’t consume it.
High-risk/high-return ETF portfolios are made up mostly of stock ETFs. After all, stocks have a very long history of clobbering most other investments — if you give them enough time. Any portfolio that is mostly stocks should have both U.S. and international stocks, large cap and small cap, and value and growth, for starters.
This model is an easier-than-easy ETF portfolio. It is a perfectly fine, workable investment model with decent (although not great) diversification. It may be enough for anyone without a great amount in savings (say less than $50,000), or someone who has more but wants to keep things as simple as simple can be.
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Whether you hold ETFs or mutual funds or individual stocks, you probably wouldn’t mind if your investments could support you. But how much do you need in order for your investments to support you?
That’s actually not very complicated and has been very well studied: You need at least 20 times whatever amount you expect to withdraw each year from your portfolio, assuming you want that portfolio to have a good chance of surviving at least 20 to 25 years.
Once you understand reversion to the mean, don’t think you have to go out and buy any ETF that has underperformed the market for years, or sell any ETF that has outperformed. But to a small degree, you should factor in reversion to the mean when constructing a portfolio.
Reversion to the mean is a statistical phenomenon that colloquially translates to the following: What goes up must come down; what goes waaaay up, you need to be careful about investing too much money in.
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If you want to use a sector investing strategy for your exchange traded fund (ETF) and other investments, know that various sectors fall in different places along the risk/return continuum.
According to the people at State Street Global Advisors (SSgA), purveyors of Select Sector SPDR ETFs, with input from Ibbotson Associates, the following sector allocations are the most appropriate for the U.
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Before you invest your money in individual stocks or bonds, exchange traded funds (ETFs) or mutual funds, you should ask yourself these questions: How much return do I need to see? And how much volatility can I stomach?
So few things in the world of investments are sure bets, but this one is: The amount of risk you take or don’t take will have a great bearing on your long-term return.
A reasonable accumulation goal of how much you should have invested (in ETFs and other investments) for most couples is 20 times the amount you spend in a year. To reach that goal, you may have to set aside a minimum of 15 percent of your salaries for a minimum of two to three decades.
For more accurate (but still ballpark) numbers, there are a number of online retirement calculators.
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If you will, try to think of your ETF and other investment retirement plans — your 401(k), your IRA — as separate vessels of money. How much your nest egg grows depends not just on how much you put into it and which investments you choose, but also which vessels you have. Three basic kinds of vessels exist.
First are your basic vanilla retirement plans, such as the company 401(k), the traditional IRA, or, for the self-employed, the SEP-IRA or Individual 401(k).
Market timing services are popping up all over the Internet. Why not? ETFs are hot. They are in the news. They sound so impressive. And there is a sucker born every minute.
Please, please, don’t fork over your money assuming that you’re going to get the secrets to instant wealth by trading ETFs. It won’t happen.
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In June 2006, an outfit called ProShares introduced the first ETFs designed to short the market. That means these inverse ETFs are designed to go up as their market benchmark goes down, and vice versa. The four original ProShares ETFs are the Short QQQ fund (PSQ), which is betting against the NASDAQ-100; the Short S&P500 (SH); the Short MidCap400 (MYY); and the Short Dow30 (DOG).
If you have a portfolio of under $10,000, or if you have a strong desire to keep your ETF investment management simple, you may be best off combining a total-market U.S. fund with a total international fund, the best of which are the Vanguard FTSE All-World ex-US ETF (VEU) and the Schwab International Equity ETF (SCHF).
Not many 401(k) retirement plans offer ETFs, but the market is “exploding” according to one industry insider. You’d think that would make lovers of ETFs jump for joy. Maybe not!
The problem with ETFs in 401(k) plans isn’t what you may think. Even though you may be making weekly contributions, the trading fees that you might normally be hit with can easily be overcome in an employee retirement plan.
Want to take a real joyride? In 2006, First Trust Advisors introduced the First Trust IPOX-100 Index Fund (FPX). You can invest in an ETF that, according to the prospectus, tracks the 100 “largest, typically best performing, and most liquid initial public offerings” in the United States.
Just prior to the introduction of the fund, the index on which it is based clocked a three-year annualized return of 33.
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Say you have a choice between investing in an index mutual fund that charges 0.15 percent a year and an exchange-traded fund (ETF ) that tracks the same index and charges the same amount.
Or say you are trying to choose between an actively managed mutual fund and an ETF with the very same manager managing the very same kind of investment, with the same costs.
Beyond the world of exchange-traded funds, an entirely different universe is filled with things called exchange-traded derivatives. A derivative is a financial instrument that has no real value in and of itself; rather, its value is directly tied to some underlying item of value, be it a commodity, a stock, a currency, or an ETF.
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ETFs are a huge part of the options market. And options can allow you to capture the gains of the stock market with very limited risk. They also allow you to invest in the market and not have to worry about downturns. What’s not to love about options?
Whoaaa. Not so fast! You need to know a couple little things about options:
They are expensive.
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Beta is a relative measure of volatility for your ETF investment. It is used to measure the volatility of something in relation to something else. Most commonly that “something else” is the S&P 500. Very simply, beta tells you that if the S&P rises or falls by x percent, then our investment, whatever that investment is, will likely rise or fall by y percent.
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How well any specific ETF fits into a portfolio — and to what degree it affects the risk of a portfolio — depends on what else is in the portfolio. This concept is called Modern Portfolio Theory and is a tool you can use to determine a proper ETF mix for your portfolio.
The theory says is that the volatility/risk of a portfolio may differ dramatically from the volatility/risk of the portfolio’s components.
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The Sharpe, Treynor, and Sortino ratios are measures of what you get for the risk in any given ETF investment or any other type of investment, for that matter.
Back in 1966, a goateed Stanford professor named Bill Sharpe developed a formula that has since become as common in investment-speak as RBIs are in baseball-speak.
Standard deviation shows the degree to which a stock/bond/mutual fund/ETF’s actual returns vary from its average returns over a certain time period.
For example, imagine two hypothetical ETFs and their returns over the last six years. Both portfolios start with $1,000 and end with $1,101. But there is a great difference in how much they bounce.
Experts don’t agree on how best to diversify the domestic-stock portion of an ETF portfolio or any investment portfolio for that matter. Two competing methods predominate:
One method calls for the division of a stock portfolio into domestic and foreign, and then into different styles: large cap, small cap, mid cap, value, and growth.
You can build yourself, at least on the domestic side of your stock holdings, a pretty well-diversified portfolio with but four ETFs: one small value, one small growth, one large value, and one large growth. With industry-sector investing, you would need a dozen or so ETFs to have a well-balanced portfolio, and that may be too many.
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These correlations of several iShares ETFs show to what degree different ETFs moved in the same direction over a recent three-year period. The lower the correlation, the better — from a portfolio-building point of view. Low correlations reduce portfolio risk. High correlations do not. Negative correlations are, alas, not that easy to find in the real world, but portfolio managers are forever looking.
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In order to put together an ETF portfolio that maximizes your return while minimizing the risk, it is helpful to understand the concept of limited or low correlation.
When the U.S. stock market takes a punch, which happens on average every three years or so, most U.S. stocks fall. When the market flies, most stocks fly.
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Exchange Traded Funds (ETFs) are the perfect investment vehicle to avoid the IRS’s “Wash Rule.” Let’s say you had a bad year on a particular investment or you had a bad year on many of your investments. Sell the investment(s) by December 31st and you can use the loss to offset any capital gains or, if you’ve had no capital gains, deduct the loss from your taxable ordinary income, up to $3,000.
If you were standing on a ship in the middle of the ocean, and you looked up and squinted real hard, you would see ETF investment dollars sailing overhead.
For at least a decade now, U.S. fund investors have been steadily adding money to the international side of their stock portfolios. According to figures from the Investment Company Institute, the average U.
It may sound like exchange-traded funds (ETFs) are not only the best thing since sliced bread but as a replacement for sliced bread. Well, not quite. As nice as ETFs are, good old mutual funds still enjoy their place in the sun. That’s especially true of inexpensive index mutual funds, such as the ones offered by Vanguard and Fidelity.
The keys to successfully manage a portfolio include diversification and patience. When considering your ETF purchases, be sure to avoid these common mistakes that investors make:
Improper Diversification
Thou shalt not put all thy eggs in one basket is perhaps the first commandment of investing, but it is astonishing how many sinners there are among us.
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Using sector ETFs can be a great way to diversify your portfolio. It also, however, can be dangerous if you use this strategy as a means to help you speculate on the market.
When to prefer the style grid for your ETFs
There is nothing wrong with dividing up a stock portfolio into industry sectors, but please don’t be hasty in scrapping style investing.
In the world of exchange-traded funds (ETFs) and other investments, after someone has a portfolio in place at a brokerage house such as Fidelity, Vanguard, or Schwab, that client is often very hesitant to switch.
Moving your account can sometimes be a big, costly, and time-consuming hassle. So if you have money to invest, it behooves you to spend some serious time researching brokerage houses and to choose the one that will work best for you.
A lack of education about investing and ETFs — combined with a surfeit of cheesy and oft-advertised investment industry products, plus an irresponsible and lazy financial press — leads many investors to make some very costly mistakes.
Pay too much for an investment
Most investors pay way, way too much to middlemen who suck the lifeblood out of portfolios, leaving too many folks with too little to show for their investments.
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Whereas investing in a socially responsible mutual fund or ETF may do the world some good, the question remains whether it will do your portfolio any good.
Proponents believe that nice companies, like nice salespeople, will naturally be more successful over time. Skeptics of investing with a social screen not only scoff at the notion of good karma but also say that limiting a fund manager’s investment choices could lead to lower performance.
The Select Sector SPDRs are on a par with the Vanguard industry sector ETFs. Like the Vanguard funds, they represent large U.S. industry groupings. They follow reasonable indexes, and they will cost you a tad less than the Vanguard ETFs — 0.20 versus 0.24 percent a year in management fees.
Select Sector SPDR offerings include the following:
U.
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Three discount brokerage houses that house exchange-traded funds (ETFs) are T. Rowe Price, TD Ameritrade, and Scottrade. All three are well-known within the investing community, each with its own advantages.
T. Rowe Price
This Baltimore-based shop has several claims to fame, including its bend-over-backwards friendliness to small investors and its plethora of really fine financial tools, especially for retirement planning, available to all customers at no cost.
Even smart investors can make mistakes in managing their portfolios, especially with the strange investment industry products on the market. When working with your ETFs, make sure to avoid these mistakes:
Not save enough for retirement
Compared to spending, saving doesn’t offer a whole lot of joy. But you can’t build a portfolio out of thin air.
The recent astonishing returns of emerging market stocks and ETFs are due in good part to sharp increases in the prices of commodities, such as oil, which come largely from these nations. But commodity prices fluctuate greatly. And political unrest, corruption, and overpopulation, as well as serious environmental challenges, plague many of these countries.
Europe is a good place to hold ETFs because it boasts the oldest, most established stock markets in the world: the Netherlands, 1611; Germany, 1685; and the United Kingdom, 1698. Relative to the stocks of most other nations, European stocks, as a whole, are seemingly low-priced (going by their price-earnings [P/E] ratios, anyway).
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You don’t really need REIT ETFs for the income they provide. Some people have this notion that withdrawing dividends from savings is somehow okay but withdrawing principal is not. Don’t make that mistake. The reality is that if you withdraw $100 from your account, it doesn’t matter whether it came from cash dividends or the sale of stock.
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The balance between stocks and bonds — and the ETFs based on them — is usually expressed as “[% stocks]/[% bonds],” so a 60/40 portfolio means 60 percent stocks or stock ETFs and 40 percent bonds or bond ETFs. The optimal balance for any given person depends on many factors: age, size of portfolio, income stream, financial responsibilities, economic safety net, and emotional tolerance for risk.
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There are three reasons that REIT ETFs are an investment class of their own. These reasons explain why REITs deserve some special status in the world of investments.
REITs offer limited correlation to the broad markets
An index of U.S. REITs (similar to the Dow Jones U.S. Select REIT Index) has evidenced a correlation of 0.
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With all that exchange-traded funds (ETFs) have going for them, it’s not surprising that they have spread like wildfire on a hot day in July. From the beginning of 2000, when there were only 80 ETFs on the U.S. market, to the end of August 2011, when there were slightly more than 1,300 ETFs, the total assets invested in ETFs rose from $52 billion to just about $1.
Some of the exchange-traded fund (ETF) providers (Vanguard, iShares, Schwab) tend to use traditional indexes, such as the Dow Jones Industrial Average. Others (Invesco PowerShares, WisdomTree, Guggenheim) tend to develop their own indexes.
For example, if you were to buy 100 shares of an ETF called the iShares S&P 500 Growth Index Fund (IVW), you’d be buying into a traditional index (large U.
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In the case of indexed ETFs and mutual funds, safety is provided (to a limited degree only!) by diversification in that they represent ownership in many different securities. Owning many stocks, rather than a few, provides some safety by eliminating something that investment professionals, when they’re trying to impress, call nonsystemic risk.
The structure of exchange-traded funds (ETFs) makes them different than mutual funds. Actually, ETFs are legally structured in three different ways: as exchange-traded open-end mutual funds, exchange-traded unit investment trusts, and exchange-traded grantor trusts. The differences are subtle.
One seminal difference between ETFs and mutual funds is basically an extremely clever setup whereby ETF shares, which represent stock holdings, can be traded without any actual trading of stocks.
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.
Although most investors are now familiar with exchange-traded funds (ETFs), mutual funds remain the most popular investment vehicle of choice by a margin of 12:1.
The reasons for the dominance of mutual funds are several. First, mutual funds have been around a lot longer and so got a good head start.
Second, largely as a corollary to the first reason, most company retirement plans and pension funds still use mutual funds rather than ETFs; as a participant, you have no choice but to go with mutual funds.
In a world of very pricey investment products and very well paid investment-product salespeople of Wall Street, exchange-traded funds (ETFs) are the ultimate financial killjoys.
Since their arrival on the investment scene in the early 1990s, more than 1,300 ETFs have been created, and ETF assets have grown faster than those of any other investment product.
Of course, purchasing ETFs leads to the technical questions about which exchange the ETF calls home and which account should house it. Here are the answers to those questions:
Does it matter which exchange your ETF is traded on?
No. Most ETFs are traded on the NYSE Arca (Archipelago) exchange, but plenty of others are traded on the NASDAQ.
Purchasing ETFs, especially for the first time, can be a daunting task. Here are some common questions about the process of purchasing funds for the first time:
Where is the best place for me to buy ETFs?
Set up an account with a financial supermarket such as Fidelity, Vanguard, T. Rowe Price, or Charles Schwab.
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Of the 100 or so large cap ETFs on the market, perhaps 20 or so are worth particular attention for tapping into the value market. The following five offer good large value indexes at reasonable prices. Read through the descriptions and make the choice that’s best for you.
The criteria to pick the best large cap value ETF should include expense ratios, appropriateness of the index, trading cost, and tax efficiency.
The best choices among small value Exchange Traded Funds (ETFs) include offerings from Vanguard and iShares. There is also an option from Guggenheim, which isn’t bad.
Whatever your total allocation to domestic small cap stocks, allocate 60 to 75 percent of that amount to small value. But no more than that, please.
Before you go out and invest all your money in ETFs, you may have some more questions. Here are some of the more common questions when it comes to ETFs:
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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Of late, a number of ETFs, including the PowerShares MENA Frontier Countries Portfolio (PMNA), the Guggenheim Frontier Markets ETF (FRN), and the Market Vectors Gulf States ETF (MES), have cropped up to allow you to invest in so-called frontier markets. These markets feature economies even smaller, stock markets even newer and potentially less regulated, and governments perhaps even shakier than in emerging market nations.
With its takeover of Rydex SGI in 2011, Guggenheim became eighth among U.S.-based ETF providers, with about $11 billion in assets. It is an interesting company with an unusual mix of products.
Many of its ETFs are largely designed for people who are unhappy buying the usual indexes and want to take something of a gamble on a particular equity style, such as large growth stocks.
Historically, the stock market takes something of a dip in one out of every three years. In the dip years, ETFs can help ease the pain.
Say it’s a particularly bad year for tech stocks, and you happen to own a few of the most beaten down of the dogs. Come late December, you can sell your losing tech stocks or 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.
Just as a deed shows that you have ownership of a house, a share of an exchange-traded fund (ETF) represents ownership (most typically) in a basket of company stocks.
To buy or sell an ETF, you place an order with a broker, generally (and preferably, for cost reasons) online, although you can also place an order by phone.
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The question of how often to rebalance an investment portfolio has been studied and restudied since long before ETFs arrived on the scene. Most financial professionals agree that once a year is a good timeframe, at least for those still in the accumulation phase of their investing careers.
Anything less frequent than that increases your risk as positions get more and more out of whack.
Asking how risky, or how lucrative, ETFs are is like trying to judge a soup knowing nothing about the soup itself, only that it is served in a blue china bowl. The bowl — or the ETF — doesn’t create the risk; what’s inside it does.
Thus stock and real estate ETFs tend to be more volatile than bond ETFs. Short-term bond ETFs are less volatile than long-term bond ETFs.
At present, you have more than 300 global and international ETFs from which to choose. (Global ETFs hold U.S. as well as international stocks; international or foreign ETFs hold purely non-U.S. stocks.) Consider the following half dozen factors when deciding which ones to invest in:
What’s the correlation? Certain economies are more closely linked to the U.
After you decide which industry sectors you wish to invest in, you need to pick and choose among ETFs. Like with other ETF options, there are a variety to choose from and a variety of companies that sell 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.
You — you personally — can’t just buy a share of an exchange-traded fund (ETF). You need someone to actually buy it for you and hold it for you. That someone is a broker, sometimes referred to as a brokerage house or a broker-dealer.
Some broker-dealers, the really big ones, are sort of like financial department stores or supermarkets where you can buy ETFs, mutual funds, individual stocks and bonds, or fancier investment products like puts and calls.
Using sector ETFs to diversify your portfolio can be an advantageous strategy. An in-depth study on industry-sector investing, done several years ago by Chicago-based Ibbotson Associates (now part of Morningstar), came to the very favorable conclusion that sector investing — because times have allegedly changed — is potentially a superior diversifier to grid (style) investing.
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The difference between investment amateurs and investment professionals can be huge. But you can close much of that gap in investing with exchange-traded funds (ETFs).
Consider a few impressive numbers
Investment professionals include the managers of foundations, endowments, and pension funds with $1 billion or more in invested assets.
After your account is in place, which should take only a few days, you’re ready to buy your first exchange-traded fund (ETF). Most brokerage houses give you a choice: Call in your order, or do it yourself online.
Calling is typically much more expensive, as it requires the direct assistance of an actual person.
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Options on exchange-traded funds (ETF) are very hot, hot, hot right now! Options on some ETFs trade almost as actively as the underlying ETFs themselves. Selling covered calls is a traditional way that many people get started in the world of options. Here is how selling a covered call, otherwise known as a buy-write strategy, works:
You buy, say, 1,000 shares of the PowerShares QQQ Trust Series 1 ETF(QQQ).
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There are some sector-based ETFs that are better choices than others for additions to a portfolio that mostly features style investments. When deciding what sector investments to add to your portfolio, you should look for low correlation to the rest of the stock market.
Some sectors, or industry subsectors, even though they are part of the stock market, tend to move out of lockstep with the rest of the market.
There are about 200 U.S. industry-sector ETFs. You can find a fund to mirror each of the major industry sectors in the U.S. economy: energy, basic materials, financial services, consumer goods, and so on.
Based on the breakdown of the MSCI U.S. Broad Market Index, this chart reveals the size of ten major industry sectors of the U.
If you’re familiar with trading stocks, you already know how to trade exchange-traded funds (ETFs). If you aren’t, don’t sweat it. Although there are all kinds of fancy trades you could make, the two most basic kinds of trades are market orders and limit orders.
A market order to buy tells the broker that you want to buy.
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Indexed funds (such as Exchange-Traded Funds and mutual funds) are safer and easier than actively managed funds. They also make more money over the long-run.
One study, done in 2010 by Wharton finance professor Robert F. Stambaugh and University of Chicago finance professor Lubos Pastor, looked back over 23 years of data.
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Fewer providers of exchange-traded funds (ETFs) exist (currently 48) than mutual fund providers, they tend to be larger companies, and the top four providers (BlackRock, State Street, Vanguard, and Invesco PowerShares) control 92 percent of the market.
In large measure this is because ETFs’ management fees are so low that a company can’t profit unless it enjoys the economies of scale and multiple income streams that come from offering a bevy of ETFs.
Invesco PowerShares, number four in size and number two in number of ETF offerings, hesitates to call all but five of its 120 ETFs “actively managed” and instead refers to them as “dynamic.”
The ETFs track “enhanced” indexes, or, to use the company’s own jargon, “Intellidexes.” An Intellidex is a custom-made index, which, according to Invesco PowerShares, “quantitatively chooses stocks for their capital appreciation potential, evaluating and selecting stocks based on multiple valuation criteria, rather than simply by market cap alone.
None of the ETFs listed below is horrible — far from it. But given the plethora of choices, barring very special circumstances, here are the reasons these options should not rank at the top of your list:
DIAMONDS Trust Series 1 (DIA): The Dow Jones Industrial Average is an antiquated and somewhat arbitrary index of 30 large companies that look good to the editors of The Wall Street Journal.
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You know that mutual funds, individual securities (stocks or bonds), and annuities are possible alternatives, or complements, to ETFs. But the investment world offers other options as well. Here are a few less commonly known investments, some of which may be worth considering for your portfolio:
Closed-end mutual funds: Just as the word burger without any qualifiers is usually understood to mean hamburger — not veggie burger or turkey burger — so are the words mutual fund usually understood to mean open-end mutual fund.
In 2006, ProShares introduced four ETFs targeting investors at the extremely optimistic end of the sentiment spectrum. These are leveraged funds that include the Ultra QQQ (QLD), which “seeks daily investment results, before fees and expenses, that correspond to twice (200%) the daily performance of the NASDAQ-100 Index,” and the similarly designed Ultra S&P500 (SSO), Ultra MidCap400 (MVV), and Ultra Dow30 (DDM).
On May 6, 2010, the stock market went kablooey. With no real reason to explain it, the stock market suddenly plunged. Some exchange-traded funds (ETFs) had fallen in value to mere pennies on the dollar. It seemed like the start of another Great Depression.
Ooops.
The “flash crash” of 2010 was just a big mistake — a few computer glitches, essentially — and within 10 minutes, the market nearly recovered.
To date, a handful of micro cap ETFs have been introduced. They differ from one another to a much greater extent than do the larger cap ETFs. Notice that the top five holdings of each ETF are completely different; you don’t find Exxon Mobil and Apple in every list, as you do with large cap growth funds.
Despite the differences, all three funds discussed next have seen rather lackluster performance since their inception.
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Most exchange traded funds (ETFs) are cheap, which is one of the things you will love about them. The difference between a typical mutual fund that charges 1.4 percent and a typical ETF that charges 0.2 percent adds up to a lot of money over time.
MoneyChimp, a very good financial website, offers a fund-cost calculator.
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If you can meet the minimums and would rather invest in any of Vanguard’s mutual funds instead of ETFs, your average expense ratio would be 0.18 percent for the Admiral shares versus 0.17 percent for the ETFs.
Indexing leader Vanguard, as low as its fund costs are, has always charged larger investors even less.
The Pacific region merits a chunk of any balanced portfolio of ETFs. The nations of the Pacific have evidenced a good comeback in recent years.
With the rapid growth of China as the world’s apparent soon-to-be largest consumer, surrounding nations may bask in economic glory. Australia, in particular, has benefited greatly from the recent run-up in prices for natural resources caused in part by Chinese demand.
The flip side of flipping ETFs is buying and holding them, which is almost certain, in the long run, to bring results far superior to market timing. It’s the corollary to choosing ETFs over stocks. Study after study shows that the markets are, by and large, efficient.
What does that mean? So many smart players are constantly buying and selling securities, always on the lookout for any good deals, that your chances of beating the indexes, whether by market timing or stock picking, are very slim.
Although more than 30 REIT ETFs are currently available to U.S. investors, a handful really stand out for their low costs and reasonable indexes. In fact, making the selection shouldn’t be all that hard.
U.S. domestic REIT ETFs
These two funds are strikingly similar, and either one fits the bill nicely when it comes to investing in the U.
PowerShares has about 50 domestic and a dozen international sector funds. The ETFs offered in this line are actively managed, with a broker picking the stocks. PowerShares industry sector offerings include the following:
U.S. Sector Fund Name
Ticker
PowerShares Dynamic Biotechnology & Genome
PBE
PowerShares Dynamic Building & Construction
PKB
PowerShares Dynamic Energy & Exploration
PXE
PowerShares Dynamic Food & Beverage
PBJ
PowerShares Dynamic Hardware & Consumer Electronics
PHW
PowerShares Dynamic Insurance
PIC
PowerShares Dynamic Leisure & Entertainment
PEJ
PowerShares Dynamic Media
PBS
PowerShares Dynamic Networking
PXQ
PowerShares Dynamic Oil & Gas Services
PXJ
PowerShares Dynamic Pharmaceuticals
PJP
PowerShares Dynamic Retail
PMR
PowerShares Dynamic Semiconductors
PSI
PowerShares Dynamic Software
PSJ
PowerShares Dynamic Telecommunications & Wireless
PTE
PowerShares Dynamic Utilities
PUI
PowerShares Lux Nanotech
PXN
PowerShares Aerospace & Defense
PPA
PowerShares WilderHill Clean Energy
PBW
PowerShares Water Resources
PHO
Global Sector Fund Name
Ticker
PowerShares Global Coal Portfolio
PKOL
PowerShares Global Nuclear Energy
PKN
Powershares Global Steel Portfolio
PSTL
PowerShares Global Wind Energy Portfolio
PWND
On the down side, PowerShares charges 0.
ProShares offers nearly the same number of ETFs as PowerShares. The Short QQQ ProShares (PSQ) allows you to short the NASDAQ 100: If the NASDAQ goes down 5 percent tomorrow, your ETF will go up (more or less) 5 percent. Of course, the inverse is true, as well.
Other ProShares offerings allow you to short the Dow, the S&P 500, or the S&P MidCap 400, among other indexes.
There are circumstances where it makes sense to trade ETFs rather than buy and hold. For example, you need to rebalance your portfolio, typically on an annual basis, to keep risk in check
Few investors walked away from 2008 smelling like a rose. But those who were slammed, truly slammed, were those who had more on the stock side of their portfolios than they should have.
The best investing strategy is to buy and hold a well-balanced portfolio (including ETFs) and rebalance it once a year. But if you insist on day trading ETFs , just play by a few rules.
After all, gambling (and that is what such short-term forays into the market are) can be fun. Not only that, but the odds of making money by gambling on an ETF are much greater than they are by, say, playing the horses, shooting craps, or standing in line at 7-11 on a Friday afternoon to buy lottery tickets.
One danger of ETFs is their ability to allow you to easily purchase into sectors, which can be dangerous when it leads to speculation. There’s little question that people who divide their portfolios into large/small/value/growth are much more likely to be long-term investors with long-term strategies than are people who buy into sectors.
The long-term performance records of short ETFs show these beasts to be dangerous for long-term investments. All of the original ProShares ETFs introduced in 2006 have lost a bundle. The ProShares Short QQQ (PSQ), for example, has lost 12.51 percent annually since inception.
But to truly appreciate the losing power of these funds, you need to look at ProFunds, the mutual funds produced by the very same people who produce ProShares ETFs.
Small cap international stocks and the ETFs that hold them have even less correlation to the U.S. stock market than larger foreign stocks. The reason is simple: If the U.S. economy takes a swan dive, it will seriously hurt conglomerates — Nestle, Toyota, and British Petroleum, for example — that serve the U.S.
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There are a few smaller brokerage houses, mostly newcomers to the investing scene, which you could consider as places to house your exchange-traded funds (ETFs):
eTrade: 800-387-2331. Not only can you house your ETFs here, but you can refinance the mortgage on your house, as well.
TIAA-CREF: 800-927-3059. A good company, but this brokerage house works only with teachers.
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An increasing number of people — both individuals and institutions — are investing using some kind of moral compass when deciding which ETFs deserve their attention. The investments chosen 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.
State Street’s flagship ETF, the first ETF on the U.S. market, is the SPDR S&P 500 (SPY). It boasts almost $80 billion in net assets, nearly twice the assets of any other stock ETF on the market. That status will likely change over time, but for now, SSgA’s pet spider gives it a firm perch as the second-largest provider of ETFs.
In addition to its Select Sector SPDRs, State Street Global Advisors offers more basic ETFs without the “Select” name. The SPDRs industry sector offerings are as follows:
U.S. Sector Fund Name
Ticker
SPDR KBW Bank
KBE
SPDR KBW Capital Markets
KCE
SPDR KBW Insurance
KIE
SPDR S&P Oil & Gas Exploration & Production
XOP
SPDR S&P Oil & Gas Equipment & Services
XES
SPDR S&P Health Care Equipment
XHE
International Sector Fund Name
Ticker
SPDR S&P International Consumer Staples Sector ETF
IPS
SPDR S&P International Materials Sector ETF
IRV
SPDR S&P International Energy Sector ETF
IPW
SPDR S&P International Technology Sector ETF
IPK
SPDR S&P International Utilities Sector ETF
IPU
SPDR Dow Jones International Real Estate ETF
RWX
Global Sector Fund Name
Ticker
SPDR Dow Jones Global Real Estate ETF
RWO
SDPR S&P Global Natural Resources ETF
GNR
A big difference between the Select Sector SPDR and the plain old industry sector SPDR lineups is price, but if you assume that the “Select” names will cost you more, surprise!
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If you are seeking a blended (large cap value and growth) investment option for smaller portfolios ($10,000 to $20,000), these ETFs are worth a look.
All the expense ratios, average cap sizes, price/earnings ratios, and top five holdings for the ETFs listed here are true as of a certain date and are subject to change.
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In the past century, small cap stocks and the ETFs based on them have outperformed large cap stocks. The volatility of small cap has also been greater. In terms of return per unit of risk (risk-adjusted rate of return), however, small caps are clearly winners. And so it would seem that investing in small caps is a pretty smart thing to do.
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If there were no trading costs involved with ETFs, then you would always be best off to hold separate ETFs for each stock style, i.e. large growth, large value, and so on.
This approach gives you the opportunity to rebalance once a year. But the profit you expect to reap from that tweak must exceed the transaction costs of making two trades (generally selling shares of the outperforming ETF for the year and adding to the underperformer).
Capitalization or cap refers to the combined value of all shares of a company’s stock. The lines dividing large cap, mid cap, and small cap are sometimes as blurry as the line between, say, Rubenesque and fat. The distinction is largely in the eyes of the beholder. If you took a poll, however, you would find that the following divisions are generally accepted:
Large caps: Companies with more than $5 billion in capitalization
Mid caps: Companies with $1 billion to $5 billion in capitalization
Small caps: Companies with $250 million to $1 billion in capitalization
Anything from $50 million to $250 million would usually be deemed a micro cap.
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To be sure, small value stocks are risky little suckers. Even the entire index (available to you in neat ETF form) is more volatile than any conservative investor may feel comfortable with. But as part — a very handsome part — of a diversified portfolio, a small value ETF can be a beautiful thing indeed.
If we knew the past was going to repeat, such as it did in the movie Groundhog Day, there’d be no reason to have anything but small value in your portfolio.
Warren Buffett knows a value stock when he sees one. Do you? Different investment pros and different indexes, upon which ETFs are fashioned, may define “value” differently, but here are some of the most common criteria:
P/E ratio: As early as 1934, Benjamin Graham and David Dodd (in their book with titled Security Analysis) suggested that investors should pay heavy consideration to the ratio of a stock’s market price (P) to its earnings per share (E).
For large growth and large growth alone, the four ETF options listed here all provide good exposure to the asset class at very reasonable cost. But please remember that holding a large growth ETF whould be complemented by large value ETF. And such a position should only be used by people with adequate assets ($20,000+).
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Many different criteria are used to determine whether a stock or basket of stocks (such as an ETF) qualifies as growth or value. But perhaps the most important measure is the ratio of price to earnings: the P/E ratio, sometimes referred to as the multiple.
The P/E ratio is the price of a stock divided by its earnings per share.
If you have a portfolio of under $20,000 or so, consider small cap blend ETFs, which combine small value and small growth stocks. Small cap domestic stocks shouldn’t occupy more than 20 percent or so of your portfolio. So keep it simple until your portfolio grows to the point that you can start slicing and dicing a bit more economically.
If you want to invest your money in companies that are smaller than small, you can invest in ETFs based on micro caps. These companies are larger than the corner delicatessen, but sometimes not by much. In general, micro caps are publicly held companies with less than $300 million in outstanding stock.Micro caps, as you can imagine, are volatile little suckers, but as a group they offer impressive long-term performance.
One word on mid cap ETFs . . . why? Yes, for the past several years mid cap stocks — investments in companies with roughly $5 to $20 billion in outstanding stock — have performed especially well. They’ve done better than large caps and have even given small cap stocks a run for their money. But such outperformance of mid cap stocks is a fluke.
Before there were exchange-traded funds (ETFs), individual securities had a big advantage over funds in that you were required to pay capital gains taxes only when you actually enjoyed a capital gain.
With mutual funds, that isn’t so. The fund itself may realize a capital gain by selling off an appreciated stock.
The superior returns of indexed mutual funds and exchange-traded funds (ETFs) over actively managed funds have had much to do with the popularity of ETFs to date. Index funds (which buy and hold a fixed collection of stocks or bonds) consistently outperform actively managed funds.
One study done by Fulcrum Financial tracked mutual fund performance over ten years and found that 81 percent of value funds underperformed the indexes, as did 63 percent of growth funds.
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On March 25, 2008, Bear Stearns introduced an actively managed exchange-traded fund (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. Prophetic? Perhaps.
In the three years since, about two dozen actively managed ETFs have hit the street, with very little commercial success.
Look at the performance records of these leveraged ETFs carefully before considering them. Take the ProShares Ultra QQQ ETF (QLD). The NASDAQ-100 index returned 3.28 percent a year in the three years prior to May 31, 2011.
And QLD, which promises twice the performance of the NASDAQ-100? That fund has returned 0.
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How much you need in ETFs and the rest of your portfolio to call yourself economically self-sufficient (or retired) starts off with a very simple formula: A × B = $$$$. A is the amount of money you need to live on for one year. B is the number of years you plan to live without a paycheck. $$$$ is the amount you should have before bidding the boss adieu.
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Unfortunately, the old-style “active versus passive” studies that consistently gave passive (index) investing, including exchange-traded funds (ETFs), two thumbs up are getting harder and harder to do. What exactly qualifies as an “index” fund anymore, now that many ETFs are set up to track indexes that, in and of themselves, were created to outperform “the market” (traditional indexes)?
Low correlation among ETFs is important because it creates a portfolio containing two asset classes that go up and down at different times. Heck, it would seem that funds that short the stock and bond markets would be ideal additions to a portfolio. Talk about diversification!
Ah, but there are hitches. For example, when you diversify, you want to find various asset classes that move out of synch but that are all expected to move upward over time, making money for you.
At the core of every ETF is an index. The index is the blueprint on which the ETF is based. Some ETF providers use old, established indexes. Others create their own, often in conjunction with seasoned indexers. (That association helps them get approval from the SEC.)
As a rule, for an ETF to be any good, it has to be based on a solid index.
In the beginning, most ETFs were traded on the American Stock Exchange. In July 2005, however, iShares decided to move its primary listings for 81 of its ETFs to the New York Stock Exchange, citing superior technology.
Then, in 2008, the American Stock Exchange was gobbled up by the New York Stock Exchange, which today goes by the name NYSE Arca.
It was perhaps foreshadowing, and somewhat ironic, that the very first actively managed ETF was issued by Bear Stearns. That was in March 2008. Within several months, the financial collapse of the investment banking industry, led by Bear Stearns, was well on its way to creating the worst bear market (more irony) of our lifetimes.
If you expect emerging market stocks and, thus, ETFs to continue to clock such phenomenal returns, you are sure to be disappointed. If you expect European stock markets to do half again as much as the U.S. markets, you are similarly in for a sad surprise.
You can expect that foreign stocks overall may do better than U.
If you own a Vanguard mutual fund and you want to convert to the Vanguard ETF that tracks the same index, you can do so without any tax ramifications.
The conversion is tax-free because you will actually be exchanging one class of shares for another class of shares, all within the same fund. You can do this only with Vanguard ETFs.
The wannabe middlemen of ETFs are about as necessary as forks in a soup kitchen, but be assured that they will continue to try to muscle in on the money.
Commissioned brokers
Most often they call themselves “financial planners,” and some may actually do some financial planning. Many, however, are merely salesmen in poor disguise, marketing pricey and otherwise inferior investment products and living off the “load.
A good number of ETFs in registration with the SEC are going to be hitting the market shortly (presuming they get the approval they seek). Of these, some will likely be issued by long-standing and respected companies, such as PIMCO (which has already entered the fray with a handful of both passive and actively managed bond ETFs) and T.
Technically speaking, two timber REIT ETFs exist: the Guggenheim Timber ETF (CUT) and the iShares S&P Global Timber & Forestry Index ETF (WOOD). You probably won’t be a big fan of either. They both charge fairly high fees (0.65 and 0.48 percent respectively), but the bigger issue is that they invest only in a handful of timber REITs, simply because there are only a handful of them.
If you have a portfolio of more than $20,000 and you can buy-and-hold, break up your small cap holdings into a growth 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.
A key to building a successful portfolio that includes exchange-traded funds (ETFs), right up there with low costs and tax efficiency, is diversification. You cannot diversify optimally unless you know exactly what’s in your portfolio.
In a rather infamous example, when tech stocks (some more than others) started to go belly up in 2000, holders of Janus mutual funds got clobbered.
Funds
The first question you have to answer when opening an account from which you can trade your exchange-traded funds (ETFs) is whether it will be a retirement account or a non-retirement account.
If you want a retirement account, you need to specify what kind (IRA? Roth IRA? SEP?). A non-retirement account is a simpler animal.
The first truly loony ETFs hit the market around 2006. At that time, a dozen funds came on the marketthat invested in companies involved in treating specific diseases. You could have invested in the Ferghana-Wellspring (FW) Derma and Wound Care Index Fund, or the FW Metabolic-Endocrine Disorders Index Fund, or the FW Respiratory/Pulmonary Index Fund.
There isn’t a single investment offered by Van Eck that your grandfather ever heard of, never mind invested in! All 35 Market Vectors ETFs offered by Van Eck Global are in “alternative” asset classes.
You won’t be investing in Procter & Gamble or McDonalds, but rather in, well, the names of a few of the ETFs will give it away .
In 2001, Vanguard launched its first ETF. It goes without saying that the people at Vanguard know something about index investing. In 1976, Vanguard launched the first index-based mutual fund for the retail investor, the Vanguard Index Trust 500 Portfolio. (Wells Fargo already had an index fund, but it was available only to endowments and other institutions.
Vanguard has 11 U.S. sector ETFs and one international ETF. These funds cover much of the domestic market. The Vanguard industry sector offerings include the following:
U.S. Sector Fund Name
Ticker
Vanguard Consumer Discretionary ETF
VCR
Vanguard Consumer Staples ETF
VDC
Vanguard Energy ETF
VDE
Vanguard Financials ETF
VFH
Vanguard Health Care ETF
VHT
Vanguard Industrials ETF
VIS
Vanguard Information Technology ETF
VGT
Vanguard Materials ETF
VAW
Vanguard REIT Index ETF
VNQ
Vanguard Telecommunications Services ETF
VOX
Vanguard Utilities ETF
VPU
Vanguard’s International sector fund is the Global ex-U.
The world of exchange-traded funds changes rapidly. New products are added to the ETF roster almost daily, some of which are reasonably priced and track indexes that make good sense, and others of which are pricey, complicated, and potentially dangerous to the investor. You cannot assume that every ETF is a good product.
Given the limitations of various savings account types, which ETFs (and other investments) should get dibs on becoming retirement assets, and which are best deployed elsewhere? Follow these four primary principles, and you can’t go too wrong:
Any investment that generates a lot of (otherwise taxable) income belongs in your retirement account.
New exchange-traded funds (ETFs) are being born every week, but at the same time, others are dying. About 150 ETFs in the past several years have been zipped up, closed down, folded, and sent to that Great Brokerage in the Sky. No need to shed tears for the investors; they are okay.
If you are holding shares in a particular ETF that closes down, you will generally be given at least several weeks notice.
Funds
Some ETFs are best kept in retirement accounts due to their ability to avoid tax hits. Not all investments, however, should be kept only in retirement accounts. Here are ETFs and other investments generally best kept in a retirement account:
Taxable bond ETFs. Examples include
iShares IBoxx $ Investment Grade Corporate Bond (LQD)
iShares Barclays TIPS Bond Fund (TIP)
PowerShares Emerging Markets Sovereign Debt Portfolio (PCY)
ETFs that invest in real estate investment trusts (REITs).
Funds
About 65 percent of the world stock market is outside of the United States. Should you invest that much of your portfolio in foreign ETFs? No, that may be overdoing it. Approximately 40 to 50 percent of your stock portfolio should be international.
There are six distinct reasons to avoid overloading your portfolio to the tune of 65 percent foreign stocks:
Currency volatility: When you invest abroad, you are usually investing in stocks that are denominated in other currencies.
Prepare yourself for the next market storm! How? The answer is fairly simple: Don’t allow any one slice of your ETF portfolio to overtake the rest. Periodically pull your portfolio back into balance.
To illustrate, imagine a simple middle-of-the-road ETF portfolio. At the start of the year, the portfolio is just where you want it to be: 60 percent diversified stocks, 40 percent bonds.
Funds
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.
When exchange-traded funds (ETFs) were first introduced, they were primarily of interest to institutional traders — insurance companies, hedge fund people, banks — who often have investment needs considerably more complicated than yours and mine.
Ability to trade lots of stocks at once
Prior to the introduction of ETFs, a trader had no way to buy or sell instantaneously, in one fell swoop, hundreds of stocks or bonds.
Funds
Some well-publicized research indicates that an 80-percent-or-so domestic stock/20-percent-or-so foreign stock portfolio is optimal for maximizing return and minimizing risk with your ETFs. But almost all that research defines domestic stock as the S&P 500 and foreign stock as the MSCI EAFE. The MSCI EAFE is an index of mostly large companies in the developed world.
WisdomTree Investments out of New York, with some fairly big-gun backers, issued 20 ETFs in June 2006. It has since launched 30 more but has closed 10 of the original lot.
Recently, WisdomTree announced plans to change the investment objectives, strategies, and fund names of eight international equity ETFs in the next few months.
The answer depends on your objective. If you are looking to round out an existing portfolio of stocks or mutual funds, your ETF should complement that. 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.
Studies show that the same value premium — the tendency for value stocks to outperform growth stocks — that seemingly exists with U.S. ETFs can be found around the world. Therefore, you might consider a mild tilt toward value in your international stock portfolio, just as for your domestic portfolio.
You can accomplish this tilt easily by using the iShares MSCI EAFE Value Index (EFV) along with the iShares MSCI EAFE Growth Index (EFG).
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