Exchange-Traded Funds For Dummies book cover

Exchange-Traded Funds For Dummies

By: Russell Wild Published: 12-02-2021

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!

Articles From Exchange-Traded Funds For Dummies

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Exchange-Traded Funds For Dummies Cheat Sheet

Cheat Sheet / Updated 10-01-2021

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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Choosing the Best ETFs

Article / Updated 03-26-2016

With about 1,300 exchange-traded funds available, where do you start to shop? The answer depends on your objective. If you are looking to round out an existing portfolio of stocks or mutual funds, your ETFs should complement your existing investments. Your goal is always to have a well-diversified collection of investments. If you are starting to build a portfolio, you want to make sure to include stocks and bonds and to diversify within those two broad asset classes. There is not much in the world of stocks, bonds, and commodities that can’t be satisfied with ETFs. Keep the following guidelines in mind as you make selections: Mix and match your holdings appropriately. You not only want a well-diversified portfolio, but you also want one that includes various asset classes that tend to go up and down in value at different times. There’s no point to holding four different ETFs that all invest in large cap stocks. Hold a large cap ETF and a small cap, a U.S. stock ETF and an international stock ETF. Go for lowest cost. As with any other investment vehicle, be careful of paying more than you need to. Although most ETFs are very economical, some are more economical than others. You may not always want to pick the cheapest, but certainly aim in that direction. Don’t sweat the small stuff. Two ETFs that track similar indexes (such as, say, large value stocks) are not going to be all that different from one another. Spend some time researching your options, but don’t agonize over your selection. Much more important — perhaps worth a little agony — is choosing ETFs that track dissimilar indexes so your eggs are in different baskets. Go passive. A handful of ETFs promise “active management.” Know that active management has an awfully spotty track record. The bulk, if not all, of your ETF portfolio should be in passively managed (indexed) ETFs. Look for breadth. Examine the holdings of the ETF. As a rule, no one security (such as, for example, Microsoft or General Electric stock) should represent more than 10 percent of the ETF’s total assets.

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How ETFs Differ from Mutual Funds

Article / Updated 03-26-2016

At first glance, an exchange-traded fund (ETF) may seem awfully similar to a mutual fund. After all, like ETFs, mutual funds also represent baskets of stocks or bonds. The two, however, are certainly not twins. Maybe not even siblings. Cousins are more like it. Here are some of the significant differences between ETFs and mutual funds: ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their price can change from second to second. Mutual fund orders can be made during the day, but the actual trade doesn’t occur until after the markets close. ETFs tend to represent indexes — entire markets or market segments — and the managers of the ETFs tend to do very little trading of securities in the ETF. (The ETFs are passively managed.) Although they require you to pay small trading fees, ETFs usually wind up costing you much less than a mutual fund because the ongoing management fees are typically much less, and there is never a load (an entrance or exit fee, sometimes an exorbitant one) as there is with some mutual funds. Because of low portfolio turnover and also the way they are structured, investment gains on ETFs usually are taxed more gingerly than the gains on mutual funds. The following table provides a quick look at some ways that investing in ETFs differs from investing in mutual funds. ETFs Mutual Funds Priced, bought, and sold throughout the day? Yes No Offer some investment diversification? Yes Yes Is there a minimum investment? No Yes Purchased through a broker or online brokerage? Yes Yes Do you pay a fee or commission to make a trade? Often Sometimes Can you buy/sell options? Yes No Indexed (passively managed)? Typically Atypically Can you make money or lose money? Yes Yes

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Websites for Up-to-Date ETF Information

Article / Updated 03-26-2016

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. Instead, always do your research before making any investment decision. How can you stay informed when the ETF market changes so rapidly? Checking in on the following websites is a great way to start: Yahoo! Finance (http://finance.yahoo.com/etf) Features a search function with intimate details on individual funds, an ETF glossary, and regularly updated news and commentary. Seeking Alpha (http://seekingalpha.com/dashboard/etfs) Features some the smartest commentary on fund investing you’ll find anywhere. ETF Database (http://etfdb.com/)Boasts daily ETF news, educational articles, analysis, and an ETF screener. Find out which ETFs represent what asset classes for the lowest fees. ETF Guide (http://www.etfguide.com/) A good, quick summary of the entire ETF world. Contains a complete listing of all ETFs available, along with ticker symbols. ETF Trends (http://www.etftrends.com/) A gossip column of sorts for ETF enthusiasts. There’s chit chat about new ETFs on the market, ETFs pending approval of the SEC, behind-the-scenes industry workings, and rumors. ETF Zone (http://www.etfzone.com/) An extremely convenient and quick way to get a scope on what’s available in the ETF world. Index Universe (http://www.indexuniverse.com/) See “News” under the Sections heading for the most up-to-date information on ETFs and index mutual funds. See the “Data” section to help screen for ETFs of your liking. Morningstar (http://www.morningstar.com/IntroPage.aspx) Click the ETF icon at the top of the screen. You can find thorough information on individual funds, along with Morningstar’s trademarked rating system. (One star is bad, five stars is grand.) See also http://etf.morningstar.com, which is the link to Morningstar’s ETFInvestor newsletter. It’s a paid publication, but there’s a fair amount of information that’s free.

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Asking a Financial Professional about Working ETFs into Your Portfolio

Article / Updated 03-26-2016

If you’re willing to spend time reading quality resources about exchange-traded funds and portfolio construction, you can create for yourself a portfolio that balances risk and potential return and aims toward your investment goals. However, many people find that they want at least a bit of guidance from a financial pro before making investment decisions. If that describes you, look for a fee-only financial planner (someone who does not earn commissions on your investments). Here are some questions to ask when you meet that person: Given my personal economics, how much risk should I be taking with my money? Specifically, what percent of my portfolio should be in stock ETFs and what percent in bond ETFs? Given the size of my portfolio, how many individual ETFs would you suggest? Which brokerage house do you recommend for housing my ETF portfolio? What is the historical rate of return on the ETF portfolio that you are suggesting, and just how volatile can it be? Given my age, my tax bracket, and my employment, what kind of account — IRA, Roth IRA, or taxable brokerage account — do you suggest for my ETFs? What selection of ETFs would you advise for an optimally diversified portfolio? Do I keep my present investments, or sell them? If I keep them, how are you going to choose ETFs that best complement those investments? Can you help me jiggle the investments in my 401(k) plan to complement my new ETF portfolio?

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Exchange Traded Funds: Systemic and Nonsystemic Risk

Article / Updated 03-26-2016

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. Nonsystemic risk is involved when you invest in any individual security. It’s the risk that the CEO of the company will be strangled by his pet python, that the national headquarters will be destroyed by a falling asteroid, or that the company’s stock will take a sudden nosedive simply because of some Internet rumor started by an 11th-grader in the suburbs of Des Moines. Those kinds of risks (and more serious ones) can be effectively eliminated by investing not in individual securities but in ETFs or mutual funds. Nonsystemic risk contrasts with systemic risk, which, unfortunately, ETFs and mutual funds cannot eliminate. Systemic risks, as a group, simply can’t be avoided, not even by keeping your portfolio in cash. Examples of systemic risk include the following: Market risk. The market goes up, the market goes down, and whatever stocks or stock ETFs you own will generally (though not always) move in the same direction. Interest rate risk. If interest rates go up, the value of your bonds or bond ETFs (especially long-term bond ETFs such as TLT, the iShares 20-year Treasury ETF) will fall. Inflation risk. When inflation picks up, any fixed-income investments that you own (such as any of the conventional bond ETFs) will suffer. And any cash you hold will start to dwindle in value, buying less and less than it used to. Political risk. If you invest your money in the United States, England, France, or Japan, there’s little chance that revolutionaries will overthrow the government anytime soon. When you invest in the stock or bond ETFs of certain other countries (or when you hold currencies from those countries), you’d better keep a sharp eye on the nightly news. Grand scale risks. The government of Japan wasn’t overthrown, but that didn’t stop an earthquake and ensuing tsunami and nuclear disaster from sending the Tokyo stock market reeling in early 2011. Although ETFs cannot eliminate systemic risks, don’t despair. For while nonsystemic risks are a bad thing, systemic risks are a decidedly mixed bag. Nonsystemic risks, you see, offer no compensation. A company is not bound to pay higher dividends, nor is its stock price bound to rise simply because the CEO has taken up mountain climbing or hang gliding. Systemic risks, on the other hand, do offer compensation. Invest in small stocks (which are more volatile and therefore incorporate more market risk), and you can expect (over the very long term) higher returns. Invest in a country with a history of political instability, and (especially if that instability doesn’t occur) you’ll probably be rewarded with high returns in compensation for taking added risk. Invest in long-term bonds (or long-term bond ETFs) rather than short-term bonds (or ETFs), and you are taking on more interest-rate risk. That’s why the yield on long-term bonds is almost always greater. In other words, Higher systemic risk = higher historical returns Higher nonsystemic risk = zilch That’s the way markets tend to work. Segments of the market with higher risks must offer higher returns or else they wouldn’t be able to attract capital. If the potential returns on emerging-market stocks (or ETFs) were no higher than the potential returns on short-term bond ETFs or FDIC-insured savings accounts, would anyone but a complete nutcase invest in emerging-market stocks?

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Exchange Traded Funds: From Wall Street to Main Street

Article / Updated 03-26-2016

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 $1.1 trillion. Certainly, $1.1 trillion pales in comparison to the $12 trillion or so invested in mutual funds. But if current trends continue, ETFs may indeed become as popular as the Beatles. Part of ETFs’ popularity stems from the growly bearish market of the first decade of this millennium. Investors who had been riding the double-digit annual returns of the 1990s suddenly realized that their portfolios weren’t going to keep growing in leaps and bounds, and perhaps it was time to start watching investment costs. There has also been a greater awareness of the triumph of indexing — investing in entire markets or market segments — over trying to cherry-pick stocks. It took from 1993 until, oh, 2001 or so for this newfangled investment vehicle to really start moving. By about 2003, insiders say, the majority of ETFs were being purchased by individual investors, not institutions or investment professionals. BlackRock, Inc., which controls about 45 percent of the U.S. market for ETFs, estimates that approximately 60 percent of all the trading in ETFs is done by individual investors. The other 40 percent is institutions and fee-only financial advisors, like me. Fee-only, by the way, signifies that a financial advisor takes no commissions of any sort. It’s a very confusing term because fee-based is often used to mean the opposite. Actually, individual investors — especially the buy-and-hold kind of investors — benefit much more from ETFs than do institutional traders. That’s because institutional traders have always enjoyed the benefits of the very best deals on investment vehicles. That hasn’t changed. For example, institutions often pay much less in management fees than do individual investors for shares in the same mutual fund. (Fund companies often refer to institutional class versus investor class shares. All that really means is “wholesale/low price” versus “retail/higher price.”)

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How to Get the Professional Edge with Exchange-Traded Funds

Article / Updated 03-26-2016

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. Amateurs include the average U.S. investor with a few assorted and sundry mutual funds in his 401(k). Let’s compare the two: During the 20-year period 1990 through 2009, the U.S. stock market, as measured by the S&P 500 Index, provided an annual rate of return of 8.2 percent. Yet the average stock mutual fund investor, according to a study by Dalbar, earned an annual rate of 3.2 percent over that same period, just barely keeping up with the inflation rate of 2.8 percent a year. Bond-fund investors did much worse. Why the pitiful returns? There are several reasons, but two main ones: Mutual fund investors pay too much for their investments. They jump into hot funds in hot sectors when they’re hot and jump out when those funds or sectors turn cold. (In other words, they are constantly buying high and selling low.) Professionals tend not to do either of those things. To give you an idea of the difference between amateurs and professionals, consider this: For that very same 20-year period in which the average stock mutual fund investor earned 3.2 percent, and the average bond mutual fund investor earned 1 percent, the multibillion-dollar stock-and-bond-and-real-estate California Public Employees’ Retirement System (CALPERS) pension fund, the largest in the nation, earned nearly 8 percent a year. You can do what they do! Professional managers, you see, don’t pay high expenses. They don’t jump in and out of funds. They know that they need to diversify. They tend to buy indexes. They know exactly what they own. And they know that asset allocation, not stock picking, is what drives long-term investment results. In short, they do all the things that an ETF portfolio can do for you.

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Indexed Funds and ETFs vs. Actively Managed Funds

Article / Updated 03-26-2016

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. The conclusion: Actively managed funds have trailed, and will likely continue to trail, their indexed counterparts (whether mutual funds or ETFs) by nearly 1 percent a year. That may not seem like a big deal, but compounded over time, 1 percent a year can be HUGE. Let’s plug in a few numbers. An initial investment of $100,000 earning, say, 7 percent a year, would be worth $386,968 after 20 years. An initial investment of $100,000 earning 8 percent for 20 years would be worth $466,096. That’s $79,128 extra in your pocket, all things being equal, if you invest in index funds. And if that investment were held in a taxable account, the figure would likely be much higher after you account for taxes. (Taxes on actively managed funds can be considerably higher than those on index funds.) Moving from the world of academia and theory to the real world, let’s look at that very first ETF introduced in the United States, the SPDR S&P 500 (SPY). Since inception in January 1993, that fund has enjoyed an average annual return of 8.26 percent — not bad, considering that it survived two very serious bear markets (2000–2002 and 2008–2009). Very few actively managed funds can match that record. By the way, SPY, as well as it has performed, has several flaws that make it far from a great first choice of ETF for most portfolios. But despite its flaws, SPY remains by far the largest ETF on the market, with total assets of $90 billion. The largest fund of any kind is the PIMCO Total Return mutual fund [PTTRX], with total net assets of $136 billion. In terms of number of shares traded daily, nothing even comes close to SPY.

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ETFs and Risk Measurement: Beta Assesses Price Swings Relative to Market

Article / Updated 03-26-2016

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. The S&P is considered our baseline, and it is assigned a beta of 1. So if you know that Humongous Software Corporation has a beta of 2, and the S&P shoots up 10 percent, Jimmy the Greek (if he were still with us) would bet that shares of Humongous are going to rise 20 percent. If you know that the Sedate Utility Company has a beta of 0.5, and the S&P shoots up 10 percent, Jimmy would bet that shares of Sedate are going to rise by 5 percent. Conversely, shares of Humongous would likely fall four times harder than shares of Sedate in response to a fall in the S&P. In a way, beta is easier to understand than standard deviation; it’s also easier to misinterpret. Beta’s usefulness is greater for individual stocks than it is for ETFs, but nonetheless it can be helpful, especially when gauging the volatility of U.S. industry-sector ETFs. It is much less useful for any ETF that has international holdings. For example, an ETF that holds stocks of emerging-market nations is going to be volatile, yet it may have a low beta. How so? Because its movements, no matter how swooping, don’t generally happen in response to movement in the U.S. market. (Emerging-market stocks tend to be more tied to currency flux, commodity prices, interest rates, and political climate.) Following are the (three-year) standard deviations and betas of several diverse ETFs. Note that iShares MSCI Hong Kong (EWH) is more volatile than iShares MSCI U.K. Index (EWU) as measured by its standard deviation, but EWH has a lower beta. That tells you that the volatility of the Hong Kong market, however great it is, seems to be less tied to the fortunes of the S&P 500 than is the volatility of the U.K. market. ETF Ticker Standard Deviation Beta SPDR S&P 500 SPY 21.8 1.0 Consumer Staples Select Sector SPDR XLP 14.7 0.59 Health Care Select Sector SPDR XLV 17.6 0.66 iShares MSCI U.K. Index EWU 27.1 1.11 PowerShares QQQ Trust Series 1 QQQ 25.1 1.07 iShares MSCI Hong Kong EWH 28.3 0.55

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